Q: What is rebalancing and why is it important?
A: Rebalancing your portfolio involves shifting your investments among different asset classes to keep your portfolio in line with your target allocation. Not only does this approach ensure that you are buying low and selling high, but can also eliminate the temptation to time the market. Since we cannot consistently predict what a particular asset class will do in the future, it is impossible to know the optimum time to sell an asset to maximize profits. But by rebalancing your asset allocation at least once a year, you will be taking advantage of market volatility and using it in your favor. You will also be keeping your portfolio in line with your risk tolerance so that you can achieve your long-term goals.
Asset classes (i.e. stocks, bonds, real estate, commodities, etc.) do not move in lock-step with each other. For example, when stock prices are heading higher, bond prices tend to fall. The opposite is also true: when stocks prices are declining, bond prices will typically increase. This performance dynamic will result in a shift in your asset allocation, and if not monitored appropriately, could leave your portfolio exposed to a higher rate of fluctuation, perhaps more than you are comfortable with.
For example, let’s say a newly retired individual chose to invest her retirement savings in a portfolio that consisted of 60% stocks and 40% bonds, which is consistent with her risk tolerance. Let’s further assume the stock market performed very well over the first two years of her retirement. Without rebalancing her portfolio, she may be surprised to find that her retirement portfolio now consists of 80% stocks and 20% bonds. This mix will be outside her comfort zone and if the stock market begins to decline, she will experience a larger decline in her portfolio due to the higher exposure to stocks. Higher fluctuation in her portfolio may cause panic and leave her no other option other than to liquidate her portfolio, at what could be a large loss. Therefore, in order to eliminate trying to time the market and avoid panic selling, you want to make sure that you rebalance your portfolio at least every year in an effort to bring your asset allocation back in line with your risk tolerance.