What portfolio rebalancing is and how it can help with investing
Those who seek to make money from the markets are often looking to balance out the risk of loss with the potential for reward. Typically the higher the risk, the higher the possible reward and vice versa.
The proportion of your portfolio you allocate to distinct asset classes will therefore depend on your investment profile and appetite for risk. In order to keep these proportions in line you will need to manage your portfolio actively through a process known as rebalancing.
Say for example you have a portfolio comprised of 60% stocks, 40% bonds (whether directly or through funds), and the stocks do well while the return from the bonds goes down.
In this case, the value of the various holdings in your portfolio will change and may now look more like 70% shares, 30% bonds.
The concept of portfolio rebalancing is that you then take your profit on the shares that have done well, and buy bonds that haven’t done as well for the time being, until the stocks part of your portfolio makes up 60% again.
This helps to keep a more consistent level of risk exposure and also encourages the discipline of selling assets that have appreciated and buying those that may have become relatively undervalued.
Seduced by high returns, some may be tempted to leave their portfolio of high-performing shares as it is, but Schroders analyst Clement Yong highlights the problem with this is that you could be ‘dangerously exposed’, and adds the ‘results can be both painful and swift’.
He highlights two past examples for stocks. First from 1974, when the FTSE All-Share Index fell by more than 70%, ‘very bad news for anyone holding a UK share portfolio’, and secondly in 2008, when the FTSE 100 dropped by 31%.
When it comes to bonds, although pointing out they are more secure than stocks, Yong gives the example of unexpected interest rate rises from the US Federal Reserve in 1994, which subsequently wiped $1.5tn from world bond markets.
‘It is true that markets do come back from such losses, but it often requires a strong stomach to last the journey,’ Yong adds. ‘For an investor, not having all your eggs in one basket can both protect your wealth and give you the confidence to stay aboard.’
Just as it is prudent to sell high-performing assets to keep a portfolio balanced, it’s important not to panic when investments are performing poorly and sell simply because that’s what everyone else is doing.
‘You could be selling out of an asset at the wrong time,’ explains Keith Speck, a portfolio analyst at Morningstar.
‘This year for example, we saw a healthy bounce back in equities. If you sold out at that point, you’d be dampening your ability to make future gains.’
FOCUS ON LONG-TERM GOALS
He adds, ‘Markets can move all the time. If you think an asset is sound and you have confidence in that asset, it probably makes sense to add to your position [if there’s a selloff].
‘Rather than get caught up in the emotions of the market, it’s best to focus on your long-term goals.’
For Andrzej Pioch, a multi-asset fund manager at Legal & General Investment Management, keeping the balance in his clients’ portfolios involves selling when the going is good in markets, and buying when others are selling if they have confidence in the asset.
‘We spend our time buying on the weakness [in share prices] and selling on the strengths,’ he says. ‘That naturally allows our allocations to remain in line.’
Pioch adds that having a balanced portfolio with different assets can help a lot in a downturn.
‘Our infrastructure and REIT (real estate investment trust) allocation was really helpful in 2018 when we saw double-digit losses in equities,’ he says. ‘Those allocations to infrastructure and REITs behaved very differently to shares in a market downturn.’
In terms of rebalancing a portfolio, Schroders found that doing it on a quarterly or annual basis could provide the best risk/return ratio.
REMEMBER THE COSTS
It’s important to keep in mind though that buying and selling stocks or bonds incurs fees from your broker, and there will be a difference between buying and selling prices for an asset.
So investors need to think carefully about whether the benefits of frequently rebalancing a portfolio outweigh the costs.