In its most basic form, portfolio rebalancing is the process of adjusting the asset weightings of one’s portfolio. You “rebalance” your portfolio by periodically buying or selling assets to maintain your original asset allocation targets.
To use a very simple example, assume that your desired portfolio allocation is 70% stocks and 30% bonds. Let’s also assume that you’ve already achieved your desired allocation. What happens if, say, stocks vastly outperform bonds? In this case, your allocation will get skewed much more in favor of stocks. If the value of your stocks increases at a significantly higher rate than your bond holdings that 70/30 allocation could become 80/20 or even 90/10 (you get the idea).
When you developed your portfolio, you set a specific allocation because it’s the one most likely to meet your investment goals and risk tolerance. This means you need to periodically rebalance the portfolio to ensure that the original allocation is maintained.
In the above example, you may need to purchase more bonds to regain your desired portfolio allocation. If you don’t, your portfolio will be skewed toward stocks more heavily than you originally intended. This may not be bad during bull markets but if stocks correct lower you will be exposed to all sorts of risks.
Against this backdrop, you now know the two main goals of portfolio rebalancing: (1) targeting risk and return characteristics and (2) controlling risks.
Want to know how to figure out your target asset allocation? Click here.