What is portfolio rebalancing and why does it matter?

What is portfolio rebalancing?

Portfolio rebalancing is the process of realigning the weightings of assets in your investment portfolio to maintain your desired asset allocation. Over time, as different investments perform differently, your portfolio's composition can drift away from your original targets. Rebalancing involves buying or selling assets to restore your intended balance.

For example, if you initially allocated 60% of your portfolio to shares and 40% to bonds, strong share performance might shift this to 70% shares and 30% bonds. Rebalancing would involve selling some shares and buying bonds to return to your 60/40 target allocation.

Portfolio rebalancing is a fundamental principle of long-term investing strategy. It helps manage risk, maintain your investment goals and could potentially improve returns over time by enforcing a disciplined approach to buying low and selling high.

Why rebalance your investment portfolio?

Without rebalancing, your portfolio could become riskier than intended. When high-performing assets grow to represent a larger portion of your portfolio, you can become more exposed to those specific investments. This concentration risk means your portfolio could be more volatile than you're comfortable with.

Rebalancing serves several important functions:

1. Maintains your risk tolerance: regular rebalancing ensures your portfolio doesn't become too aggressive or too conservative over time. As you age or your circumstances change, your ability to handle market volatility may shift. Rebalancing keeps your portfolio aligned with your current risk profile.

2. Enforces investment discipline: rebalancing can remove emotion from decision-making. During market highs, it can be tempting to chase performance by holding onto winners. Rebalancing forces you to take profits from outperforming assets and invest in underperforming ones, which aligns with the principle of buying low and selling high.

3. Prevents overconcentration: rebalancing can stop you from becoming too exposed to any single asset class or investment. This diversification benefit could help protect your portfolio from significant losses if one particular investment performs poorly.

How to rebalance your portfolio

The process of rebalancing involves three key steps and considerations.

1. Setting your target allocation

Before you can rebalance, you need to establish your target asset allocation. This is the ideal mix of different asset classes (such as shares, bonds, property and cash) that aligns with your investment goals, time horizon and risk tolerance.

A younger investor with a longer time horizon might target 80% shares and 20% bonds, accepting higher volatility for potential long-term growth. An investor nearing retirement might prefer 40% shares and 60% bonds to reduce risk as they prepare to withdraw funds.

Your target allocation should reflect your personal circumstances, financial goals and comfort with market fluctuations. There is no one-size-fits-all approach.

2. Monitoring your portfolio

Once you've established your target allocation, you'll want to monitor how your actual allocation changes over time. Most investors check their portfolio quarterly, semi-annually or annually to assess whether rebalancing is needed.

You'll compare your current allocation to your target. For instance, if your target is 60% shares and 40% bonds, but your portfolio has drifted to 65% shares and 35% bonds, you may need to rebalance.

3. Making adjustments

When your portfolio has drifted from its target allocation, you have several options for rebalancing:

Sell and buy: this is the most direct method. You sell a portion of the overweighted asset and use those proceeds to buy more of the underweighted asset. Using the example above, you would sell 5% worth of shares and use that money to buy bonds.

Use new contributions: if you regularly add money to your portfolio, you could direct new contributions towards underweighted assets rather than selling overweighted ones.

Adjust dividend and interest reinvestments: instead of automatically reinvesting dividends and interest into the same assets, you could redirect these payments to underweighted portions of your portfolio.

When to rebalance your portfolio: timing strategies

There are three main approaches to deciding when to rebalance.

1. Time-based rebalancing

This approach involves rebalancing at set intervals, regardless of how much your allocation has drifted. Common timeframes include:

• Annual rebalancing: reviewing and adjusting your portfolio once per year, often at the same time each year for consistency.
• Semi-annual rebalancing: checking your portfolio twice per year, which may be appropriate for more volatile portfolios.
• Quarterly rebalancing: reviewing your portfolio four times per year, though this frequency may result in higher transaction costs without significant benefits for many investors.

Time-based rebalancing is straightforward and removes emotional decision-making from the process. However, it may lead to unnecessary rebalancing if your portfolio hasn't drifted significantly.

2. Threshold-based rebalancing

With this strategy, you only rebalance when an asset class deviates from its target allocation by a predetermined percentage. For example, you might set a threshold of 5%, meaning you'll rebalance only if any asset class is 5 percentage points or more away from its target.

If your target is 60% shares but the actual allocation reaches 65% or drops to 55%, you would rebalance. If it stays between 55% and 65%, no action would be needed.

Threshold-based rebalancing can be more efficient because you only act when a meaningful drift has occurred. However, it requires more frequent monitoring to identify when thresholds are breached.

3. Combination approach

Many investors use a hybrid strategy, checking their portfolio at regular intervals (such as quarterly) but only rebalancing if allocations have exceeded predetermined thresholds. This combines the discipline of scheduled reviews with the efficiency of threshold-based action.

Different rebalancing strategies

Strategic rebalancing

This is the most common approach, where you maintain a fixed target allocation and regularly rebalance back to those targets. The goal is to maintain consistent risk exposure regardless of market conditions.

Tactical rebalancing

Some investors make temporary adjustments to their target allocation based on market conditions or economic outlook. For example, they might slightly increase bond allocation if they believe shares are overvalued. This approach requires more active management and market timing, which can be difficult to execute successfully.

Constant proportion portfolio insurance

This more advanced strategy involves dynamic rebalancing based on portfolio value. When the portfolio value increases, you increase exposure to riskier assets. When it decreases, you shift to more conservative investments. This approach aims to protect capital during downturns while participating in upside potential.

Advantages and disadvantages of portfolio rebalancing

What to consider before rebalancing your portfolio

Transaction costs 

Every time you buy or sell investments, you may incur trading fees, commissions or spreads. Frequent rebalancing can erode returns through these costs. Consider whether your investment platform offers low-cost or commission-free investing and factor these expenses into your rebalancing strategy. When investing with us, you’ll do so through a share trading account, which enables you to buy and sell physical company shares. 

Portfolio size

Smaller portfolios may face challenges with rebalancing due to minimum investment requirements or the impact of flat trading fees. If your portfolio is modest in size, less frequent rebalancing might be more practical. As your portfolio grows, more precise rebalancing becomes easier to implement.

Rebalancing thresholds

Decide how much drift from your target allocation you're willing to tolerate before taking action. Setting thresholds (such as 5% deviation) could help you avoid unnecessary rebalancing while ensuring your portfolio doesn't drift too far from your targets.

Time and effort

Rebalancing requires monitoring your portfolio and executing trades. Consider whether you have the time and inclination to manage this yourself or whether an automated solution might be more appropriate for your circumstances.

Investment timeframe

Your investment horizon affects how critical rebalancing is. If you're decades away from needing your investments, short-term allocation drift may be less concerning. Those closer to retirement or with shorter timeframes may need more frequent rebalancing to manage risk.

Currency considerations

If your portfolio includes international investments, currency fluctuations can affect your allocation. Factor in currency conversion costs and timing when rebalancing across different currencies.

Market conditions

While rebalancing should generally be mechanical rather than based on market timing, extreme market conditions might warrant consideration. During severe market downturns, for instance, you might choose to delay rebalancing slightly to avoid selling at the market bottom, though this introduces emotion into what should be a systematic process.

Automated rebalancing and technology

Technology is making rebalancing more accessible and efficient. Many investment platforms now offer automated rebalancing services, often called robo-advisors, which monitor your portfolio continuously and rebalance automatically when needed. 

These services typically use algorithms to optimise rebalancing for efficiency and transaction costs. As technology advances, more sophisticated rebalancing strategies may become available to individual investors at lower costs.

Understanding portfolio rebalancing and implementing a consistent strategy can help you maintain discipline in your investing approach and keep your portfolio aligned with your financial goals over time.

FAQs about portfolio rebalancing

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