Why It’s Important to Rebalance Your Investment Portfolio Regularly
After creating an investment portfolio everyone wants to let it sit and not worry about it. You often hear how buy and hold strategies are the way to go and that you can often beat the market by simply being patient. While this can be true, it’s more intelligent to keep a regular eye on your asset allocation and rebalance your portfolio according to the asset mix that you predetermined.
How can this make a difference for the success of your portfolio? Say a stock that you own has increased by 20%. If your original intention was to have a 60% stocks 35% fixed income and 5% cash asset allocation and because the increase in the stock has made it 70%/27%/3% you should consider rebalancing.
Choosing the Right Asset Allocation for Your Portfolio
The first step is to select your asset allocation. If you don’t have one, you don’t have anything to rebalance your portfolio to. A simple asset allocation strategy that works is using your age as the fixed income percentage while having around 5% in cash. So if you are 35, you would have 60% stocks 35% fixed income and 5% cash. This way as you grow older, your stock exposure will decrease and your fixed income allocation will increase.
By choosing the right asset allocation for your investments, you also limit the risk in your portfolio and this is extremely important. Risk and reward are often linked and so by choosing an investment portfolio that has controlled risk, you will be able to get decent returns without blowing up your account.
For more information about asset allocation strategies, visit this great article at Investopedia.com.
http://www.investopedia.com/articles/04/031704.asp#axzz1SNO4di5E
Limit Rebalancing Your Portfolio
So first I tell you to rebalance regularly and now I’m telling you to limit the number of times you rebalance? Now you’re wondering if I’ve really lost it! “Regularly” is a pretty relative to term. I personally rebalance my portfolio to the target asset allocation either when I think it’s necessary or take a look every 6 months or so. I use the tactical asset allocation strategy where I see where the market is and how my assets are doing. This way, if a stock is performing well and the market shows signs of doing better I stay with that stock until I feel that the market is slowing down. This takes experience however and if you’re not sure how to do this, I would stick to more conventional asset allocation strategies like Strategic asset allocation whereby you focus to maintain your original asset allocation.
So back to the point. I say limit the number of times you rebalance your portfolio because there are a couple downsides to rebalancing too often. First, by rebalancing you have to incur at least two transactions costs. You are selling one asset to buy one or more assets, unless you keep your proceeds in cash. If you do this too often, you will defeat the purpose of rebalancing because you are incurring a lot of transaction fees which can hurt the returns of your investment portfolio.
What Asset Categories to Choose From
The basic asset categories are stocks, fixed income and cash. If you read around you will often see bonds instead of fixed income, but I would much rather prefer fixed income because it gives me more choice to choose from but you are more than welcome to use bonds instead. Stocks seem pretty straight forward but actually take a lot of consideration. What country’s stocks are you going to buy? Are you going to buy large cap or small cap stocks? What industries are you going to your an emphasis on?
Most of us don’t have the time to be going through thousands of stocks. And that’s where mutual funds come in. If you’re read some of my articles, I’m not the biggest fan of mutual funds but I do confess they are an important part of many people’s investment portfolios. And they should be, especially for those that are just starting out and creating their portfolios. If you investment in mutual funds, portfolio rebalancing is often taken care of and this is always a great benefit. In addition, if you choose the right mutual fund that suits your needs, it will have the optimal asset allocation as well.
As always believe in KISS, keep it simple stupid. Don’t try to over complicate things and stick to what you are comfortable with. Asset allocation can seem like a daunting task but it really isn’t. You don’t have to make things exactly according to the preset asset allocation. The optimal asset allocation is simply a guideline and it’s up to you keep it as close as you feel necessary.
Kyoto Temple photo by Sprengben on Flickr.
