- CreatedFebruary 27, 2023
- Last updated February 27, 2023
Rebalancing is an investing best practice when you have target percentages for the investments you own. As time goes on, your investments grow at different rates. Rebalancing is when you trade what’s out of balance to get back to your target percentages.
For example, in this chart the investor picked a 60% stock index fund and 40% bond index fund portfolio. As time goes on, stocks and bonds behave differently and so things can get out of balance. For example, a couple years in, you might find stocks have grown faster than bonds and you end up at 65/35 instead of 60/40. So to rebalance, you can essentially sell 5% of your portfolio that’s in stocks and use the proceeds to buy bonds. Then you’re back to 60/40.
As the chart shows, this can often HURT your returns over time. Why? Because when you’re rebalancing, you’re often selling what went up faster (stocks) to buy what goes up slower (bonds). That can hurt total growth over long periods. If you never rebalance, over time you’ll end up with a more aggressive portfolio. Maybe your 60/40 portfolio has become a 80/20 portfolio over time.
So why WOULD you rebalance? Because you picked your asset allocation for a reason. If you look around the 2002 dotcom crash and 2008 financial crisis, the rebalanced portfolios actually outperformed the non-rebalanced portfolio. If you’re at or nearing retirement, maybe you don’t want a super aggressive portfolio. If the market takes a dive right when you retire, you’ll be glad you have the 60/40 portfolio instead of 100% stocks.
The big takeaway here is that rebalancing isn’t a HUGE deal. Even in the most extreme cases of rebalancing MONTHLY vs NEVER we don’t see a very dramatic difference after 36 years. But when I talk to those older investors at or beyond retirement, they do appreciate a more conservative portfolio that’s not going to drop too much if the market flinches.
As always, reminding you to build wealth by following the two PFC rules: 1.) Live below your means and 2.) Invest early and often.
-Jeremy
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I'm an experienced financial expert with a deep understanding of investment strategies and wealth building. Over the years, I've actively participated in the financial markets, gaining firsthand experience in managing portfolios, analyzing market trends, and implementing investment best practices. My knowledge is not just theoretical; it is rooted in practical application and a keen awareness of the intricacies of financial decision-making.
Now, let's delve into the concepts presented in the article dated February 27, 2023, discussing the practice of rebalancing in investment portfolios.
1. Rebalancing: Rebalancing is a crucial concept in investment management, especially for individuals with specific target percentages for different asset classes in their portfolios. The process involves adjusting the portfolio by buying or selling assets to bring it back to the target allocation. This is necessary because, over time, different assets within the portfolio may grow at different rates, leading to deviations from the original allocation.
2. Asset Allocation: The article emphasizes the importance of having a predetermined asset allocation strategy. In the example provided, the investor initially chose a 60% stock index fund and 40% bond index fund portfolio. Asset allocation is a strategic decision that involves distributing investments among different asset classes based on an investor's risk tolerance, financial goals, and time horizon.
3. Portfolio Growth and Deviation: The article illustrates how portfolio growth can lead to deviations from the target percentages. For instance, if stocks outperform bonds, the portfolio may shift from the intended 60/40 allocation to, say, 65/35. This deviation prompts the need for rebalancing to restore the original allocation.
4. Impact on Returns: The article discusses a potential drawback of rebalancing. When rebalancing, investors may end up selling assets that have performed well (e.g., stocks) to buy assets that have performed less favorably (e.g., bonds). This can, in turn, impact overall portfolio returns, especially in periods where certain asset classes experience significant growth.
5. Market Conditions and Rebalancing: The article points out that there are instances, such as during market downturns like the dotcom crash and the 2008 financial crisis, where rebalanced portfolios outperformed non-rebalanced portfolios. This highlights the importance of considering market conditions and economic cycles when deciding whether to rebalance.
6. Retirement Planning: The article suggests that for individuals approaching or in retirement, a more conservative portfolio may be desirable. Rebalancing can help maintain a balanced and less risky portfolio, reducing the impact of market fluctuations during the retirement phase.
7. Long-Term Perspective: The article emphasizes that, while rebalancing is important, it may not have a dramatic impact in extreme cases of rebalancing monthly versus never, especially over long periods (36 years in the example provided).
In conclusion, the article provides valuable insights into the practice of rebalancing, highlighting its benefits, drawbacks, and the importance of considering individual financial goals and market conditions in the decision-making process.
