3 Things About Portfolio Rebalancing

Portfolio Rebalancing can improve returns and lower the risks of investing over time. In this post, we will explore 3 things to keep in mind when rebalancing your portfolio.

The usual disclaimer: none of this is investment advice. Any examples or references used are just for information and illustration. 

1. Know why rebalancing works

John Nersesian, head of advisor education at Pimco Asset Management, said “Rebalancing doesn’t work every time, it works over time”. This is because the ‘rebalancing effect’ forces investors to buy low and sell high.

For example, assume:

• Bob invests in 5 funds
• Bob invests 20% of his portfolio into each fund

The table below shows the returns of each fund over 5 years:

Annual percent return of Bob’s 5 funds.

Let’s now compare two scenarios for Bob:

1. Bob does NOT rebalance his portfolio
2. Bob rebalanaces his portfolio once per year back to 20% in each fund

No rebalancing scenario:

Value of Bob’s portfolio each year when he does not rebalance.

In the ‘no-rebalancing’ scenario, Bob’s £5,000 portfolio grows to £7,665 after 5 years. This would give Bob a total return of £1,665, or 53.30% over 5 years. We can calculate Bob’s compound yearly return as:

Compound Yearly Return = (1 + 53.30%)^(1/5 years) – 1 = 8.92%

Because Bob does not rebalance each year, the percentage that each fund takes up in his portfolio changes over time. For example after the first year, Fund 4 did the best (+15%) and Fund 2 did the worst (-18%). Therefore, Fund 4 will now take up more than 20% (£1,149) of Bob’s portfolio and Fund 2 will take up less than 20% (£819).

If Bob does not rebalance, in year 2 the returns of Fund 4 will impact his portfolio more than the returns of Fund 2.

Now let’s see what Bob’s return would be if he rebalanced his portfolio each year back to 20% in each fund:

Annual rebalancing to 20% in each fund:

Value of Bob’s portfolio when he does rebalance.

When Bob rebalances each year, his £5,000 portfolio grows to £8,057 after 5 years. This equates to a profit of £3,057 (61.14%), or a compound annual return of 10.01%:

Compound Yearly Return = (1 + 61.14%)^(1/5 years) – 1 = 10.01%

By rebalancing his portfolio each year, Bob earns an extra 1.09% per year on his investments. Over many years, this could add up!

The above numbers are just hypothetical, but there are many studies which show why reblancing works. By reblancing your portoflio each year, you buy more of what went down and sell some of what went up. In other words, rebalancing ensures that you buy low and sell high.

2. Rebalancing works best with uncorrelated investments

Spreading your portfolio over uncorrelated asset classes can improve diversification. For example, your portfolio might include:

• Equities
• Bonds
• Gold
• Bitcoin

Once you know your asset classes, you can decide how to invest in them. If you want exposure to stocks or bonds, for example, you may want to invest in funds or ETFs.

Depending on your risk tolerance, you can assign a percentage of your portfolio to each investment. This will give you a long-term rebalancing target. As an example, assume you choose the below target portfolio:

• Equity Fund 1 (30%)
• Equity Fund 2 (20%
• Bond Fund 1 (20%)
• Bond Fund 2 (10%)
• Gold ETF (15%)
• Bitcoin (5%)

Each month, quarter or year, you could rebalance back to your target (whatever that may be) to make sure you aren’t over-exposed to one investment. Rebalancing and diversification go hand in hand.

3.  Investing should be practical and cheap

An easy way to rebalance is to invest a set amount each month. This way each time you invest, you could top up where needed to get back to your long-term rebalancing target. If you invest lump-sum, then rebalancing once per year could be more practical. In this case, you could sell a portion of your investments that have done better over the year and use the proceeds to buy more of your investments that have done worse.

But beware of trading costs when rebalancing as these can add up over time. Personally, I hold most of my investments in funds. Unlike ETFs or stocks, fund units are often free to buy or sell on platforms like Hargreaves Lansdown.