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The Brilliance Of: Part 4 - Rebalancing

The Brilliance Of: Part 4 - Rebalancing

| June 23, 2021

Last week we talked about diversification and how building a portfolio out of multiple categories and companies helps mitigate the risk of “putting all your eggs in one basket.” This week, we talk about rebalancing, which is also a risk management method for your investments. 

Weighing Your Wealth

When you develop an investment portfolio, it is recommended that you decide what weight you would like to give your investments. Let’s you decide you want your assets to be composed like this: 40% stock and 60% bonds. If your bonds steal the limelight and have a fantastic year, their increased worth could shift the composition of your portfolio to 70% bonds instead of 60%. It’s great that their value has risen, and you made money from their boom, but the risk level associated with 70% weight in bonds might make that boom look a little too big. That’s understandable, booms can turn into bombs really quick, and the decision to drop that extra weight is a little like protecting yourself against a potential burst. 

Rebalancing is the act of periodically looking over your investments and analyzing whether or not they have changed to exceed the desired level of asset allocation or risk. After taking the time to look over your investments, you can determine the updated distribution of your wealth due to the market's movements and decide what needs to be rebalanced so that it matches the target allocation you began with. As a result, you have the opportunity to sell your stocks while they are high and bring the amount down to comfortable levels. 

Diffuse and Diversify 

So, rebalancing is a little like defusing the bomb of higher risk. Little did you know, rebalancing can help you diffuse as well as diversify—a double whammy when it comes to asset protection and risk reduction. 

When you choose to rebalance your assets and sell your stocks when their weight becomes greater than you had bargained for, you have the opportunity to take money earned from the sale and use it to reinvest in other areas. If you’re smart (which you are if you’re reading this), you would reinvest it in diversified areas - areas, unlike the stocks you currently own. That’s right, last week's diversification lesson has come back to haunt you. The ghost might be annoying, but he’s right and probably rich - I’d listen to him. 

When to Rebalance 

Well, that depends on how much time you want to spend pouring over your investment portfolio and its makeup. Since we’re talking about money here, it's tempting to say you’d like to hover over it like a helicopter mom looking at her favorite child. I get it; stocks are like children, too. They throw temper tantrums, they react dramatically to small events, you never know what they’re gonna do next, and they have a tendency to make you lose your money. But we still love them because sometimes they make us proud (and because hopefully, they will help pay for our retirement).

There is a helicopter mom method for rebalancing, and it looks a little like this: one of the most responsive ways to rebalance would be to assign a target weight to each asset and allowing for a small corridor (such as 5%) of increase or decrease in that weight before immediately rebalancing to match the target. This is intriguing because it oozes a sense of control. But before you choose it, remember that one con includes the cost. The constant reassurance that comes with continuous rebalancing will cost more than other, less responsive ways. Whew, that was a lot of C’s. 

Calendar rebalancing is a little more laid back and a little less expensive. It works by simply assigning specific dates to your rebalances and looking over your portfolio at those predetermined times. If you notice your assets have changed weight in ways that make you uncomfortable, you rebalance your portfolio back to your targets. Then, repeat the process next time. The sweet spot for checking in is typically monthly or quarterly because it gives the assets some time to make their adjustments, but not enough time to make such significant adjustments that your portfolio has changed entirely. Yearly rebalancings would likely be too long, and you could come back to a portfolio that barely resembles the one you saw last year (again, just like kids!). Still, calendar rebalances have the downside of being a little riskier than more responsive versions because the market could move massively in between the times you set aside to check on your assets. 

The Bottom Line 

Rebalancing is a great way to regulate risk, and there are multiple ways to do it. Ultimately, the best way to rebalance depends on the types of assets you own, the type of risk you are comfortable with, and your personal financial goals. Not to sell myself here, but weighing all of those factors and coming up with the best financial plan to match them is sort of my job, so if you need a little help you know who to call (no, please not ghostbusters). 


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