Why Balancing Your Portfolio Is Vital
Balancing your portfolio is a vital part of investing. The proportion of your funds that are invested in stocks, bonds, cash, and possibly less common assets, will determine how your wealth grows.
A more substantial proportion of bonds leads to greater stability and security; a larger portion of stocks to growth; and more cash improves liquidity.
How you balance your portfolio will depend upon your goals, which might be something like providing for your kids’ education or achieving a particular growth in wealth.
Whatever your goals and whatever the balance, it’s not enough just to set the proportions at the start. To achieve those goals, you’ll need to keep rebalancing your portfolio.
Dealing with Change
The main reason you’ll need to rebalance is that markets change. This will affect the allocation of resources within your portfolio in ways you can’t always predict.
For example, if your distribution is 50% stocks and the stock market does well, that 50% will grow faster than the rest of your portfolio. Left alone, it will become 55% of your portfolio, then 60%, and so on.
Your portfolio will throw itself out of balance, meaning that it no longer fits your risk tolerance and life goals.
Regular rebalancing is therefore important to keeping on target. It can also help avoid some of the pitfalls of investing.
It’s easy to be driven by your emotions when making investment decisions.
A downturn that makes your stocks look bad can induce panic and selling them off at the least profitable time.
On the flip side of that, it can feel wrong to sell off shares that are doing well, even though such sales are necessary to make a profit off of stocks.
Regular rebalancing in line with a set strategy can help you to make logical decisions instead of giving in to emotions. This can improve your growth and help you achieve your goals.
An Eye on the Big Picture
That focus on goals is vital. In an ever-changing market, it’s easy to get sucked into short- term decisions that don’t favour your long-term good.
By having a goal and keeping your eye on the big picture, you’re more likely to do well with your money.
For that big picture, you need to decide a few specific things:
- What’s your goal in investing?
- What’s your risk tolerance? A riskier strategy, with a higher proportion of stocks, can be more profitable if it pays off, but that “if” is there for a reason. Depending on your goal, you may need to play it safe.
- What’s your investment time horizon? If you’re saving for retirement and that’s 20 years away, you can pick investments that won’t pay off anytime soon. But if you need the money to pay the kids’ way through university next year, then things look very different.
- How much liquidity do you need? If you might need to access funds from your portfolio quickly, then you need more liquidity, as reflected in cash investments.
Knowing the answers to these questions will let you find the right balance in the first place and focus your mind on returning to it during rebalancing.
Approaches to Rebalancing
There are two approaches to regularly rebalancing a portfolio – the periodic approach and the deviation approach.
The periodic approach involves rebalancing at set intervals. For example, you might decide to look at your assets once a quarter or once a year at the same time you tackle your taxes.
Set reminders for yourself to do the rebalancing and make space in your schedule to do it properly.
The deviation approach involves rebalancing your portfolio whenever it shifts too far from your ideal balance. For example, you might act any time the proportion of bonds becomes 5% higher or lower than you’ve aimed to make it.
This approach makes your balancing responsive to the market and allows you to make appropriate decisions in times of rapid change. Its downside is that it generally involves more work.
You have to keep an eye on your portfolio so that you know when to act.
If the market is rapidly changing, then you’ll have to put in more effort and may incur higher trading costs.
Whichever approach you take, when the time comes to rebalance, look at which assets represent more of your portfolio than they should.
Pick some of those assets that you can profitably sell off and then reinvest those funds to get your portfolio back on target.
Once it’s done, you can leave it to take care of itself until the next rebalancing.
Staying Flexible While Staying on Target
Like your investment goals, the approach you take to rebalancing will depend on what suits your lifestyle and mentality. And just like your investment goals, it doesn’t have to be set in stone.
As life changes, you can reconsider whether your goals are still the same and adjust both your balancing and your rebalancing schedule in line with them.
These are tools to keep you on target and help you make decisions, not restrict you from following your dreams.
Paul Connolly
Paul Connolly has been a journalist for more than 20 years, as a reporter and editor for Argus Media, Reuters, The Times, Associated Newspapers and The Guardian. He has covered Islamic Finance for Reuters in the 1990s. Paul has since helped launch three newspapers, as well as reported from Tokyo, Los Angeles and Stockholm.
