For many of us, investing is how we save for retirement, college education and other life events. After setting our financial goals and building a diversified portfolio, we can watch our investments grow over time. But as the years go by and situations change, we may need to adjust those investments. That’s where portfolio rebalancing comes in.
Essentially, portfolio rebalancing acts as a tune-up for your investments. It ensures your risk tolerance aligns with your long-term financial goals and gives you a chance to review the types of investments you hold.
How rebalancing works
When it comes to rebalancing, the first step is to take a look at your asset allocation.
Asset allocation is the mix of investments you own such as stocks, bonds, funds, real estate and cash. This asset allocation takes into account your risk tolerance and financial goals.
Someone who is more risk-tolerant might have a higher allocation to historically risky assets like stocks or cryptocurrencies. On the other hand, a risk-averse investor might opt to have a higher weighting to less volatile asset classes like bonds or real estate.
When constructing a portfolio, the key is to understand how each asset class may impact your overall performance. By having a balanced portfolio, you are mitigating your risk of capital loss while increasing the likelihood of generating returns.
Once you determine your optimal asset allocation, there is a good chance those weightings will change as gains and losses accumulate.
Consider a portfolio composed of 60 percent stocks and 40 percent bonds at the start of the bull market in 2009. By now, that asset allocation would have changed to about 85 percent stocks and 15 percent bonds. Why? Because the stock market has significantly outperformed the bond market, up more than 450 percent from the market bottom.
For an investor close to retirement, such an asset allocation could be too aggressive, especially if the stock market were to enter a correction.