Imagine that you have a portfolio consisting of 10 diverse stocks from different sectors with equal allocations. After a year, you revisit the portfolio and discover that a rally in oil prices caused the oil stock to rise in value — it accounts for more than half of your portfolio’s value!
The rally in oil prices was good for your portfolio over the past year, but allocating more than half of your current portfolio to an oil stock is risky. If oil prices fell, your entire portfolio would drop in value. Equal weighting between the 10 diverse stocks could mitigate these risks.
Let’s take a look at why it’s important to rebalance your portfolio to maximize your risk-adjusted returns.
Learn about other portfolio management concepts here.
Understanding Portfolio Rebalancing
Research has shown that 88% of volatility in a diversified portfolio can be traced back to asset allocation.
In other words, two diversified investors with the same asset allocation will have roughly the same performance regardless of the specific investments that they chose.
Portfolio rebalancing is the process of maintaining asset allocations as prices change over time. When the portfolio drifts from the target allocation, sell some assets and buy other assets to restore the balance. The goal is to minimize relative risk rather than maximize returns.
Let’s take a look at a simple example to see how it works.
Suppose that an investor holds 60% stocks and 40% bonds — an allocation based on their goals.
If stocks outperform during a given year, the investor could end up with 80% stocks and 20% bonds. This portfolio may be inappropriate for the investor’s risk tolerance, time horizon, and financial goals.
By selling stocks and using the proceeds to buy bonds, the investor could maintain the 60% stocks and 40% bonds allocation within a certain threshold. This means that the riskiest the portfolio would ever become is 65% stocks and 35% bonds, which would help the investor to meet their goals.
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The Pros and Cons of Rebalancing
Portfolio rebalancing is critical to maintaining asset allocations, which are arguably the most important decision in the portfolio construction process. Without the right asset allocations, investors may be taking on too much risk for their life stage, investment goals, or risk tolerance levels.
The drawback is that rebalancing a portfolio involves costs.
When buying and selling any assets, investors must pay transaction costs and any capital gains taxes. They may also experience small losses from bid/ask spreads and slippage that can add up to significant amounts over time.
Balancing these pros and cons is accomplished with rebalancing thresholds.
Rebalancing every month with a low threshold could result in thousands of trades designed to maintain asset allocation. Each of these trades involves commissions and may have important tax consequences. But yearly rebalancing with a 5% threshold could strike a better balance between risk and cost.
There are several other strategies that can be used to rebalance a portfolio that is beyond the scope of this article.
For example, investors may prioritize selling long-term holdings rather than short-term holdings when rebalancing to avoid paying ordinary income tax rates.
Track how your portfolio’s dividend income changes when stocks increase or decrease their dividend by using our Free Dividend Assistant.
How to Automate Rebalancing
Portfolio rebalancing can be a complex topic, especially after considering the many different approaches. Fortunately, there are many tools available for investors to use when rebalancing their portfolios or ensuring that their asset allocations are appropriate to reach their financial goals.
Some of the most common approaches include:
- Target date retirement funds automatically rebalance portfolios based on your age.
- Robo-advisors automatically rebalance portfolios based on individual client requirements.
- Financial advisors have access to software that automatically identifies the best way to rebalance a portfolio.
The Bottom Line
Asset allocation is one of the most important factors in portfolio construction, but without regular rebalancing, these allocations can drift from their targets. The key to success is establishing the right thresholds and strategies for rebalancing in a way that minimizes the costs and maximizes the benefits.
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