Rebalancing Your Investment Portfolio: How to Optimize Your Investments

Have you ever wondered how top investors maintain their portfolios in perfect balance, maximizing profits while minimizing risk? The answer lies in portfolio rebalancing, a strategy used by both large institutional players and individual investors. Its premise is remarkably simple: adjusting the proportions of financial instruments in a portfolio to maintain their target allocation levels.

But what exactly is the “right” allocation? How do you perform rebalancing? And why might it be superior to the “buy and forget” strategy many retail investors use? We’ll answer these and more questions in the article below.

What is Investment Portfolio Rebalancing?

Rebalancing typically involves buying and selling portions of your portfolio to reset the weight of each asset class back to its original or target allocation. Through periodic rebalancing, investors can ensure their portfolios remain aligned with their risk tolerance and investment goals.

For example, if the original target asset allocation was 60% stocks and 40% bonds (considered the most secure and optimized portfolio), and after a period of strong performance, the portfolio shifted to 70% stocks and 30% bonds, rebalancing would involve selling some stocks and buying bonds to return to the 60/40 target level.

How does rebalancing work? Source: etrade.net

Understanding and implementing a robust rebalancing system is crucial for long-term investment success. However, it may come with a few “challenges.”

Pros and cons of portfolio rebalancing:

Pros	Cons
Maintains desired risk level	Can be time-consuming
Encourages disciplined investing	May incur transaction costs
Can improve long-term returns	Potential tax implications
Reduces emotional decision-making	Requires ongoing monitoring

How to Rebalance Your Portfolio

Determining the right time to rebalance your portfolio is crucial for maintaining your desired asset allocation and managing risk. There are three basic approaches you can use:

1. Time-based rebalancing
2. Threshold-based rebalancing
3. Life event-based rebalancing

Although a 60/40 portfolio will typically underperform the broad S&P 500 stock index in normal market conditions, it proves ideal during periods of market panic. For example, when the S&P 500 fell by almost 50% after 2008, the mixed portfolio lost 30% and recovered much faster. The S&P 500 needed almost 10 years from 2008 to surpass the 60/40 returns following the great financial crisis

From 2008 to 2017, the 60/40 portfolio performed better than the S&P 500. Source: longtermtrends.net

Time-based rebalancing This approach involves adjusting your portfolio at specific time intervals, regardless of market conditions or portfolio performance. It’s simple and easy to implement:

• Annually, for example at the beginning or end of the year
• Semi-annually
• Quarterly
• Monthly

Time-based rebalancing has the advantages of being simple and disciplined. However, it may not always capture optimal rebalancing opportunities.

Threshold-based rebalancing

This method triggers when asset allocations deviate from their targets by a predetermined percentage. It requires more engagement but directly responds to market movements:

• Fixed thresholds: for example, 5% or 10% above or below the target allocation for each asset class.

This strategy allows for better risk management but requires more attention to your portfolio.

Life event-based rebalancing

This approach involves reassessing and potentially rebalancing your portfolio when significant life events occur:

• Career changes
• Marriage or divorce
• Birth of a child
• Receiving an inheritance
• Approaching retirement

Hybrid approaches

Many investors and financial advisors use a combination of these methods to optimize their rebalancing strategy. For example:

• Combining time-based and threshold approaches: Checking the portfolio annually but also rebalancing if certain thresholds are exceeded during the year.
• Using different thresholds for different asset classes: Applying narrow ranges for more volatile assets and wider ones for more stable assets.

Popular Portfolio Rebalancing Strategies

Now that we know WHEN to rebalance the portfolio, the question is HOW to do it. The three most popular strategies are:

1. “Sell high, buy low”
2. New contributions
3. Using dividends and interest

“Sell high, buy low”

This is the most basic rebalancing strategy. It involves selling assets that have gained value above their target allocation and using the proceeds to buy underperforming assets.

This method effectively forces you to sell assets when they’re potentially overvalued and buy assets when they’re potentially undervalued, aligning with the fundamental investment principle of buying low and selling high.

New contributions

Instead of selling overvalued assets, you simply invest more in underweighted instruments. This approach works particularly well for investors who regularly add new funds to their portfolios.

For example, if your allocation to international stocks has fallen below the target level, you can use your next contribution to buy more of these securities.

Using dividends and interest

Rebalancing using dividends (from stocks) and interest (from bonds) involves redirecting investment income to underweighted asset classes. Instead of reinvesting dividends and interest back into the assets that generated them, you use this income to purchase assets in underweighted categories.

Similar to new contributions, you’re simply using available cash to balance your portfolio proportions.

Rebalancing Guide for Beginners

Do you Want to try portfolio rebalancing but need help knowing where to start? Begin with these five simple steps:

1. Review current asset allocation
2. Determine target asset allocation
3. Calculate the difference between current and target allocation
4. Choose a rebalancing strategy
5. Execute rebalancing transactions

Review current asset allocation

The first step in the rebalancing process is to take a comprehensive look at your portfolio’s current composition. Create a detailed inventory of all your investments across various accounts, including retirement accounts, taxable brokerage accounts, and any other investment vehicles.

Calculate the current percentage allocation of each asset class (e.g., stocks, bonds, real estate) in your portfolio. You can find many online tools that facilitate this process, for example, Portseido:

Portseido is a free portfolio rebalancing calucaltor. Source: Portseido.com

The tool from Curvo.eu also looks interesting; it shows you how the return rate on your investment historically changes depending on the rebalancing rules adopted.

A 60/40 portfolio for stocks and bonds along with various rebalancing strategies. Source: Curvo.eu

Determine target asset allocation

Next, reassess your investment goals, risk tolerance, and time horizon to confirm or adjust your target asset allocation. It should reflect a mix of different instruments that balances potential gains with an acceptable level of risk.

We recommend the widely used allocation of 60% stocks and 40% bonds for beginners. Harry Markowitz popularized this portfolio in the 1950s, suggesting it as the optimal solution from a risk-return perspective.

Calculate the difference between current and target allocation

Compare your current asset allocation with your target allocation and identify any discrepancies.

For example, if your goal is 60% stocks and 40% bonds, but your current allocation is 80% stocks and 20% bonds due to market performance, you’ll need to make adjustments to bring the portfolio back to your targets.

Choose a rebalancing strategy

Select a rebalancing strategy that suits your needs and preferences. Typical approaches were discussed above.

Execute rebalancing transactions

Once you’ve determined which assets need adjustment, it’s time to execute the necessary transactions. This typically involves selling overweighted assets and buying underweighted ones.

It’s best to conduct sales within tax-advantaged accounts like IRAs or 401(k)s to avoid tax liabilities. The transaction will be internal, avoiding any tax obligations!

Common Mistakes to Avoid

While portfolio rebalancing is crucial for maintaining desired asset allocation and managing risk, it’s easy to make mistakes that can negate its benefits:

• Overreacting to short-term market fluctuations - remember that market fluctuations are normal and often temporary. Responding too quickly to these movements can lead to unnecessary transactions and potentially harm your long-term investment strategy.
• Ignoring transaction costs - too frequent trading also means additional brokerage fees, bid-ask spreads, and potential tax consequences.
• Lack of considering the “bigger picture” - Some investors make the mistake of focusing solely on individual asset classes or accounts without considering the entire investment portfolio.

Portfolio Rebalancing and Risk Management

One of the primary functions of rebalancing is to keep portfolio risk in check by:

• Preventing excessive exposure to any single asset class
• Ensuring portfolio diversification
• Keeping investments aligned with risk tolerance

Rebalancing is not just about risk management; it’s primarily about optimizing investment returns. You achieve this by:

• Enforcing disciplined investing
• Capturing gains
• Maintaining diversification
• Adjusting to the investment horizon

Remember that while rebalancing can help manage risk, it doesn’t guarantee higher returns or completely eliminate risk. The effectiveness of rebalancing depends on various factors, including market conditions, specific assets in the portfolio, and the rebalancing strategy.

Keep in mind that the key to effective rebalancing is consistency, discipline, and aligning the strategy with your individual investment goals. Try it now to put the power of rebalancing to work for you.