What is the rebalancing of a portfolio and why is it important?

When investing, it’s really important not to get carried away by emotions. Making hasty decisions can negatively impact investments. That’s why a strategy known as portfolio rebalancing is essential.

Rebalancing an investment portfolio helps investors maintain their desired asset allocation over time. This process helps rebalance the portfolio based on financial market movements as well as the investor's risk profile.

As markets fluctuate, the value of assets within a portfolio can rise or fall. That way the proportions originally assigned to each asset can be deviated. This adjustment process helps restore the portfolio to its original allocation, reflecting the investor's goals and risk tolerance.

As an example, a moderate-profile investor has a traditional investment portfolio with an exposure of 60% to equities and 40% to fixed income. If stock markets have risen a lot, causing stocks to appreciate more than bonds, the allocation may shift to 70% in equities and 30% in bonds. This can mean that investors are exposed to a greater risk than they originally intended.

The rebalancing would involve selling part of the assets that have risen the most - in other words, shares - in order to reduce their weight in the portfolio and buying assets whose proportion has fallen. The investor would once again have a 60/40 portfolio once the process is completed.

Rather than just a one-off action, balancing should be viewed as a strict procedure which ensures investments remain aligned with long-term goals. This process can be performed periodically or when there's a very large deviation from the initial objectives.

Some investors prefer going for a rebalance based on time. This type involves adjusting the portfolio at regular time intervals, i.e. every three months, every six months or every year.

On the other hand, others prefer rebalancing due to deviation tolerance. This involves adjusting the investment portfolio when an asset class exceeds a certain percentage of the original objective. For instance, if the deviation is 5% or 10%.

Advantages to rebalancing

1. Controlling the risk: The main advantage of rebalancing lies in being able to maintain the risk level the investor wants. If this doesn't happen, investors could jeopardize their financial objectives due to greater exposure to risk assets.
2. Managing emotions: The rebalancing process forces investors to sell top-performing assets and buy those that have underperformed. This process requires a great amount of discipline for investors, who must break the emotional trend of buying expensively (because it's fashionable) and selling cheaply (when an asset falls).
3. Optimizing long-term profitability: Investors must always have a long-term vision. By protecting the portfolio from having very high exposure to risk assets, it can help protect the portfolio as well as reduce the impact of stock market declines.
4. Constantly diversifying: Rebalancing the portfolio ensures that it maintains the diversification set up in the original investment plan. This helps reduce the risk of being exposed to a single asset type.

While rebalancing offers clear benefits, it comes with a few challenges too. Portfolio adjustment may involve costs for investors, such as transaction fees. That’s why good financial planning is essential.