Pros And Cons of Portfolio Rebalancing.Portfolio rebalancing refers to the process of adjusting the allocation of assets in an investment portfolio to maintain a desired level of risk and return. While it has several potential benefits, there are also some drawbacks to consider. Let’s explore the pros and cons of portfolio rebalancing:
Everything in life requires balance, and an investment portfolio is no exception. From time to time it needs to be balanced and brought back to its original structure. This process is called “portfolio rebalancing”. This is what it looks like.
10 Pros And Cons of Portfolio Rebalancing.
Pros of Portfolio Rebalancing:
- Risk Management: Rebalancing helps manage risk by ensuring that your portfolio does not become overly concentrated in a particular asset or asset class. By periodically realigning your investments, you can maintain a diversified portfolio, reducing the impact of any one investment on your overall returns.
- Maintain Asset Allocation Targets: Rebalancing allows you to stay in line with your desired asset allocation targets. Over time, as certain assets outperform others, the allocation can drift from your original intentions. Rebalancing brings it back to the desired allocation, ensuring that your portfolio reflects your risk tolerance and investment goals.
- Buy Low, Sell High: Rebalancing often involves selling assets that have performed well and buying those that have underperformed. This practice follows the principle of selling high and buying low, as you sell appreciated assets and purchase undervalued ones. It can potentially enhance returns by taking advantage of market fluctuations.
- Discipline and Long-Term Perspective: Portfolio rebalancing encourages disciplined investing and helps investors maintain a long-term perspective. It prevents emotional decision-making based on short-term market movements, as it requires adhering to predetermined rules for adjusting the portfolio.
Cons of Portfolio Rebalancing:
- Transaction Costs: Rebalancing incurs transaction costs, such as brokerage fees, bid-ask spreads, and taxes. Frequent rebalancing can increase these costs and potentially erode the returns of the portfolio. It is important to weigh the benefits of rebalancing against the associated expenses.
- Missed Market Opportunities: When rebalancing, you may be forced to sell assets that continue to perform well, potentially missing out on further gains. If a particular asset class or investment is experiencing a strong positive trend, rebalancing can limit your participation in that growth.
- Rebalancing Mistakes: There is a risk of making errors when rebalancing, such as mistiming the market or miscalculating the appropriate asset allocation. These mistakes can have negative consequences on the overall portfolio performance.
- Tax Implications: Rebalancing can trigger taxable events, particularly if you sell investments that have realized gains. Capital gains taxes may need to be paid, reducing the overall return on the portfolio. Tax-efficient strategies should be considered to minimize the impact of taxes.
In summary, portfolio rebalancing has several potential advantages, including risk management, maintaining asset allocation targets, and buying low while selling high. However, it also has drawbacks such as transaction costs, missed market opportunities, the potential for rebalancing mistakes, and tax implications.
What does portfolio rebalancing look like?
Let’s say your portfolio model is 60% equity funds and 40% bond funds. As the share price rises, your share in the stock may increase up to 70%. This means that you need to sell 10% of the shares and buy additional bonds if their share has decreased. In this way, you restore the original asset class allocation in the portfolio.
However, the sale of profitable assets in the portfolio will result in the need to pay income tax. If this is not what you need, you can rebalance your portfolio by replenishing your brokerage account and purchasing sagging assets. And to summarize all that has been said, then:
- Rebalancing is the process of restoring the original shares of assets in a portfolio in accordance with its structure.
- There are two ways to restore the balance of the investment portfolio:
- Sell assets that have risen in price and buy those that have fallen in price with this money.
- Deposit money into a brokerage account and increase the proportion of assets that have sunk.
The first method will require paying tax on income from the sale of profitable assets, the second – saving money to replenish the portfolio.
Is portfolio rebalancing mandatory?
Yes, it is required. Because if nothing is done and the structure of the portfolio is not restored, then the very meaning of portfolio investment is lost. The portfolio becomes less predictable and more volatile. On this score, there is an illustrative study from the Vanguard company .
This research tested a portfolio of global stocks and global bonds in equal shares (50/50) from 1926 to 2014.
In the first case, the portfolio was rebalanced once a year, in the second, it was not touched. As a result, the share of shares in the portfolio without rebalancing increased over time to 97%.
As a result, its average annual profitability turned out to be higher (8.9% versus 8.1%). But the annual volatility also increased (13.2% versus 9.9%). This means that even though a portfolio without rebalancing brought in more money, it could have sagged more than a portfolio with rebalancing.
How often should the portfolio be rebalanced?
You can restore the balance of the portfolio at a specified frequency, for example, once a month, quarterly, half a year or a year. But the results of portfolio testing show that it is most effective to rebalance once a year or once every six months, not more often.
In turn, in the study from Vanguard, portfolios were also rebalanced at different intervals. The results showed that changing the frequency of balancing does not affect portfolio performance as much as its absence. Therefore, the presence of the rebalancing itself is more important than its frequency.
However, if you plan to maintain the structure of the portfolio through the sale of assets that have risen in price and the purchase of sagging ones, then taking into account the arising commission costs in two directions (sale – purchase), it is not worth it, in my opinion. It is enough to review the portfolio once every six months or a year.
Another approach to portfolio rebalancing
Along with the most common way to rebalance a portfolio over time, there is also a portfolio management option based on technical indicators. We talked about it at the webinar How to build a portfolio of ETFs? and below I give a video with an excerpt just on this topic.
In the comments below, write what you have arisen on this post and what option of portfolio rebalancing seemed to you optimal for your strategy of working in the market.