One of the biggest questions in the investment world with no sure answer is ‘when should investors rebalance their portfolios?’. Many financial experts recommend rebalancing your portfolio at least once a year. Others will recommend rebalancing once each equator. No matter how often an investor rebalances their portfolio, the idea behind it is that they decide in advance what their appropriate asset allocation should be. Once decided, the investor then buys and sells the various asset classes to ensure their asset allocation remains constant. Essentially, this means that the investor is periodically selling some of their top performing assets and buying some more of their worst performing assets. Seems counterintuitive, right? Let’s take a look at an example.
An investor has $200 in their investment portfolio. They decide that they spit the portfolio between two asset classes (asset allocation). To split their portfolio, they put 50 percent into stocks and 50 percent into bonds. At the beginning of the year, since they started with $200 dollars, both asset classes have $100 in them. During that year, bonds appreciate by 20 percent, while their stock investment remains flat. At the end of the year, the investor will have $110 in bonds, and still only $200 in stocks. Their stocks now represent only 45 percent of their portfolio, while bonds now account for 55 percent. This allocation is different from the investors intended allocation of 50-50 in each asset class. To re-balance, they will need to sell $5 worth of stocks and buy $5 of bonds, such that you have $105 in each asset class.
Why Does Portfolio Rebalancing Make Sense?
If the example above does not make much sense, think of rebalancing as a strategy that is meant to help investors automatically buy low and sell high, increasing their overall profit. Rebalancing enables investors to purchase discounted assets that have depreciated or have failed to incline as much while taking some profits out of those segments that have seen a run-up in value.
The Risks of Portfolio Rebalancing
While portfolio balancing can increase the received returns, there are a few things to keep an eye out for:
Counter-Productive Market Timing
The purpose of rebalancing is to remove judgment and emotion from the asset allocation process — emotional investing is one of the biggest mistakes investors can make! Trying to out-guess or predict the market, or trying to determine when the best time to buy or sell will most likely lead to losses. Instead, it is better to pick a specific date (or dates) each year to rebalance your portfolio, no matter the condition of the current market. Trying to time the market is comparable to stock-picking — it likely will not work out in the favor of the investor.
By definition, portfolio rebalancing involves selling winning asset classes, which are more than likely to have capital gains. For this reason, the act of rebalancing is susceptible to creating a tax liability for you. One of the best strategies investors can use to avoid this loss is to rebalance their portfolio by solely using assets within tax-advantaged accounts such as 401ks and IRAs. Some experts believe that re-balancing that creates a tax liability may defeat the whole purpose of the strategy, which maximizes your returns in the long run.
Of course, you are only supposed to rebalance at least once a year, but you should never be rebalanced every day, every week, or even every month. Some consider quarterly rebalances to be a bit excessive. Trading is costly, and one of the best ways to destroy your returns is to improve your costs by excessive buying and selling.
Avoid Risk With Investment Portfolio Management Software
While there are a few risks associated with portfolio rebalancing, the investment strategy can be beneficial for your investing efforts. With AlphaDroid, one of the leading financial portfolio management software, the process of portfolio rebalancing is expedited while mitigating any risk. Using this financial planning software will help investors and traders save time and will make it easier for them to review an entire overlook of their investments. If you are interested in experiencing the power of ALphaDroid, begin your free trial today!