Portfolio Rebalancing: What It Means and Why It Matters
Portfolio rebalancing is the process of reviewing an investment portfolio and considering whether its current mix of investments still reflects the intended allocation, financial goals and risk preferences.
What Is Portfolio Rebalancing?
Over time, investments can change in value at different rates. As a result, the percentage of a portfolio represented by each investment or asset category may move away from the original allocation.
Rebalancing generally involves considering changes that may bring the portfolio closer to its intended structure.
If one part of a portfolio grows or falls faster than another, the portfolio's overall mix can change. Rebalancing is the process of reviewing whether that new mix still matches the investor's intended approach.
Why Can a Portfolio Become Unbalanced?
Different investments do not always perform in the same way. Some may rise in value while others decline or remain relatively stable.
This can gradually change the weight of different investments within the portfolio, potentially changing its overall exposure to certain risks.
Suppose an investor originally divides a portfolio between two broad investment categories. If one category increases significantly in value while the other changes very little, the first category may become a larger percentage of the overall portfolio than originally intended.
Why Rebalancing May Matter
A portfolio may have been created with particular financial goals, time horizons, liquidity needs and risk considerations in mind. Significant changes in the portfolio's composition may mean that its current structure no longer closely reflects the original approach.
Reviewing the allocation can help an investor understand whether the portfolio has changed in a meaningful way.
How Rebalancing Can Be Approached
There is no single rebalancing method that is appropriate for every investor. Approaches may differ depending on portfolio size, investment costs, taxes, financial goals and other circumstances.
Some investors may review allocations periodically, while others may consider changes when an allocation moves beyond a chosen range. The appropriate approach depends on the individual situation.
Costs and Taxes
Buying or selling investments may involve transaction costs, tax consequences or other expenses depending on the investment and jurisdiction.
These factors can be important when considering any portfolio changes.
Rebalancing Does Not Guarantee Better Returns
Portfolio rebalancing is a risk-management and portfolio-maintenance concept. It does not guarantee higher returns or protect an investor from market losses.
A rebalanced portfolio can still decline in value, particularly during periods of broad market stress.
Changes in Personal Circumstances
Rebalancing is not only about market movements. Financial goals, income, expenses, time horizon and liquidity needs can also change over time.
A review may therefore involve considering whether the intended allocation itself still makes sense, rather than simply returning the portfolio to an old target.
Questions to Consider
- Has the portfolio changed significantly from its intended allocation?
- Do current financial goals remain the same?
- Has the investment time horizon changed?
- Has the ability to tolerate investment losses changed?
- Could taxes or transaction costs affect potential changes?
- Are there upcoming liquidity needs?
- Is the portfolio heavily concentrated in any particular area?
Key Takeaways
- Portfolio rebalancing involves reviewing changes in an investment portfolio's allocation.
- Different investment performance can change the relative size of portfolio holdings.
- Rebalancing may help maintain an intended investment approach.
- Costs, taxes and personal circumstances can affect rebalancing decisions.
- Rebalancing does not guarantee profits or prevent investment losses.
- The appropriate approach depends on individual financial circumstances and goals.