Stay on Track by Rebalancing Your Portfolio
The asset allocation of your portfolio of funds can shift over time due to changing market conditions. Rebalancing helps the asset allocation of your portfolio stay in line with your investment goals, risk profile and time horizon.
Asset allocation refers to allocating an investor’s investments across different asset classes, which is determined according to his or her investment goals, time horizon and risk profiles. Changes in the trend of equity and bond markets will cause the asset allocation of an investment portfolio comprising stocks and bonds to change over time. As a result, the portfolio may deviate from its original recommended asset allocation.
To overcome this problem, portfolio rebalancing ensures that investments in a portfolio stay in line with the investor’s intended asset allocation. This rebalancing strategy entails adjusting the mix between equity, bond and money market funds within a portfolio according to the recommended asset allocation.
The benefits of periodic portfolio rebalancing include helping investors to (1) maintain their desired asset allocation, (2) lock in gains during market uptrends and (3) remain focused on their long-term investment objectives during periods of elevated market volatility.
1. Maintaining desired asset allocation
A well-balanced portfolio, determined according to your investment goals, time horizon and risk profile, is one where the fund’s portfolio is invested across different asset classes. However, due to market movements, asset classes that have performed well in the past may now account for a larger share of your portfolio while slower performing asset classes becomes proportionately smaller. When the asset allocation of your portfolio has shifted significantly from its original position, the risk profile of your portfolio is no longer in line with its original risk profile.
Rebalancing to maintain your portfolio’s original asset allocation will ensure that risks remain spread across a variety of asset classes. Furthermore, this safeguards the risk profile of your portfolio by moving it back in line with your own risk appetite.
2. Locking in gains in periods of market uptrend
Rebalancing also gives you the opportunity to lock in unrealised gains in your portfolio of funds. During periods of market uptrend, you may find that certain asset classes, such as selected equity funds, which have outperformed are now above the original intended allocation. Thus, rebalancing the portfolio by trimming the asset class that has outperformed will help you to safely secure unrealised investment gains with the proceeds subsequently invested in other asset classes.
3. Remaining focused on long-term investment objectives
When it comes to making financial decisions during periods of elevated market volatility, our emotions can often overwhelm rational thinking. During such times, we often find it difficult to stick to our investment goals and strategies as markets may not move in tandem with our expectations. This can eventually lead to panic selling as a result of losing focus on our long-term goals.
Thus, employing a strategy of periodic rebalancing can reduce stress associated with making investment decisions in periods of elevated market volatility. By periodically assessing and rebalancing your portfolio, you can maintain self-discipline and remain focused on your long-term goals regardless of market conditions.
The following illustration demonstrates how a portfolio can change over time and explains how you can rebalance it. The pie chart comparisons show the asset allocation of the same portfolio as at August 2016 and a year later.
Chart 1 assumes the recommended asset allocation of a moderate risk investor, as at August 2016, who aims to achieve long-term capital growth by choosing an asset allocation which comprises 65% in equity funds, 25% in bond funds and 10% in money market funds.
Assuming the stock market performs well within a one year period, the equity portion of the fund portfolio will have increased to 80%. This will result in the exposure to bond investments declining to 14% as shown in chart 2.
As the equity exposure of 80% is above the original allocation, the investor can reduce the equity portion back to 65% and use the proceeds to increase the bond funds’ exposure back to its original allocation of 25%.
However, if the stock market has trended lower over the same period, the equity portion of the fund will have fallen to 40%. This will result in the exposure to bond and money market investments increasing to 43% and 17% respectively as shown in chart 3.
As the fund portfolio’s current equity exposure of 40% has moved below the original allocation, the investor can reduce the bond and money market portions back to 25% and 10% respectively and use the proceeds to increase the equity funds’ exposure back to its original allocation of 65%.
A word of caution to investors would be that excessive rebalancing will incur higher transaction costs which would adversely impact overall investment returns. Therefore, investors are advised to practise portfolio rebalancing on a scheduled basis such as half-yearly or annually.
Rebalancing your investment portfolio plays an important role in achieving your investment objectives over the long-term. It restores your investment portfolio to the targeted asset allocation that is consistent with your specific risk profile. Thus, periodic portfolio rebalancing helps you to stay on track with your financial goals.
This article is prepared solely for educational and awareness purposes and should not be construed as an offer or a solicitation of an offer to purchase or subscribe to products offered by Public Mutual. No representation or warranty is made by Public Mutual, nor is there acceptance of any responsibility or liability as to the accuracy, completeness or correctness of the information contained herein.