Once you know how to properly rebalance, you’ll have mastered one of only a few simple keys to long-term investment success.
A “balanced” portfolio is defined according to your pre-defined mix of investments. For example, you may keep a certain proportion of equities (stocks and stock funds) to bonds (the debt of corporations or municipalities), say 60/40. This means that 60% of the value of the portfolio is made up of equities with the other 40% of value in bonds.
Or your portfolio can be 100% bonds or all equities. Once you decide on how to divide your account (stocks, bonds, or both), you will break each segment down further into “asset allocations” in each category. We will illustrate with an all equity fund portfolio.
Let’s say we put $100,000 in a brokerage account on 1/2/2015. We then purchase the stock mutual funds and ETFs in the below chart, leaving $4,000 in cash (“liquid”). Because stock prices change constantly, January 2 is the only day of 2015 your portfolio had perfect “balance”. I recommend rebalancing annually at about the same time of the year.
Now it’s 1/2/16 and you want to rebalance. Let’s say your REIT and International funds grew 25% last year and now make up 20% of the portfolio each (1.25% * 16% = 20%) while the others are now worth only 14% of your portfolio. In addition, your overall portfolio neither gained nor lost money in 2015, which is pretty much what happened, so it’s still valued at $100,000.
Here’s how you would rebalance:
The beauty of rebalancing is that you are forced to sell the overpriced funds of your portfolio while they are high and replace them with stocks that are selling low, or at a discount, even though your emotions may be screaming at you to do the opposite.
Because you made the decision to keep your portfolio invested per your pre-determined allocations of 16% per category (above), you are abiding by rules you set up when you were thinking rationally – not when you are emotional about the market. To rebalance because you’ve decided to do so in advance takes away the temptation to buy more of a fund that is overpriced or to sell a quality fund that has merely experienced a down year. This allows you to tap into growth through market cycles.
I mentioned that rebalancing is only one of the keys to long-term investing success. To find out the others, watch Keys to Investing Success.