In my last sharing, I mentioned that rebalancing a portfolio is important to the success of the portfolio strategy.
Rebalancing is the process of resetting the weightings of a portfolio of assets. It involves periodically buying or selling assets in a portfolio to maintain an original or desired level of asset allocation or risk, in order to avoid undesirable risks.
Let’s take the 50/50 portfolio as an example, 50% stock ETF and 50% bond ETF. After a certain period of time, the weights of each component will move away from their original settings of 50/50 to e.g. 75/25. So what you need to do during rebalancing is to reset the 75/25 weight allocation back to the original 50/50 by buying the asset that is over 50% and selling the asset that is lower than 50%. In this case, you need to sell the stock ETF by 33% to reach 50% and buy another 25% of bond ETF to reach 50%. Yes, just that simple.
You might question- “isn’t it just selling the assets that is making profit and buying the asset that’s losing money? That’s crazy. Usually we just leave the growing one to grow even higher.” Yes, you are right, but that’s exactly why people usually end up losing money than otherwise, because of the higher than desirable risks they are exposed to when the asset keeps growing. Imagine if the market starts to perform badly and you are holding the asset more than you can accept- You end up losing more.
Besides, the core of rebalancing is selling at high and buying at low, like a machine with no emotion engaged. When it’s time to rebalance, you execute, to avoid being exposed to risks higher than you can take. Rather than saying it’s a rule, I like to back it up with some science- mean regression. No asset keeps growing infinitely and decreasing infinitely.
Rebalancing by selling low and buying high meets two goals: risk control and extra return. Here’s some back-testing figures to show the returns of a rebalanced and un-rebalanced portfolios over a time span from 1972 to 2011 (cited from The Permanent Portfolio from Harry Browne). The portfolio after rebalancing achieved a higher return than the one without rebalancing. It was also proven that the volatility of the portfolio after rebalancing is much lower than the one without.
And how often should you rebalance the portfolio?
With some back-testing data, the recommended frequency is once per year or once per quarter (if you can’t help adjusting it 😃). Once in a year is also adopted by most of the classic portfolio strategies, such as the Permanent Portfolio from Harry Browne and the All-Weather Portfolio from Ray Dalio. Tax is a common reason to do as little rebalancing as possible since you are subject to capital gain every time you sell the profiting assets. If your portfolio is more complicated and has a large value, you can try to split the rebalancing to be done over 1–3 months.
So don’t forget to schedule your rebalancing in your calendar in case you are too comfortable with the return, well, it’s stress free after all. 😁
Until then, stay calm and invest with peace.
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Disclaimer: all the content in the newsletter does not serve as financial advice. The data referred in the examples are all historical data and do not guarantee future return. Remember, investment always comes with risks.
