What is portfolio rebalancing and why is it so important?
By Mike Narouei, Content Producer at Boring Money
21 Nov, 2018
If you ask Investopedia (https://www.investopedia.com/terms/r/rebalancing.asp) for a definition of portfolio rebalancing, you’ll be served up the following:
“Rebalancing is the process of realigning the weightings of a portfolio of assets. Rebalancing involves periodically buying or selling assets in a portfolio to maintain an original desired level of asset allocation.”
Right. So in a nutshell, if you planned to have 50% shares, 25% (https://www.boringmoney.co.uk/learn/articles/what-is-portfolio-rebalancing/#) and 25% cash – a cocktail that naturally shifts over time as some investments grow and others shrink – you would ‘rebalance’ the mixture to get back to what you planned. But what does that actually look like?
Let’s use Gin and Tonic as an example
Say you like your G&T to be 50% gin, 25% tonic and 25% lime cordial. It may be strong but that’s the way you like it! After a few sips, a friend tops you up with another splash of gin. Now your cocktail is 60% gin, 20% tonic and 20% lime cordial. Bleurgh! No. This drink needs to be rebalanced to get back to the flavour you’re comfortable with.
Simple enough – just add more tonic and cordial, or find a way to take out some gin. (Yeah, that’s where this metaphor falls down! So let’s go back to your portfolio.)
Rebalancing in super simple investment terms…
Your portfolio is worth £1,000 and, as discussed, 50% is made up of shares. Let’s say you have Disney, Apple, Marmite, Facebook and Lidl – evenly split with £100 on each.
If Marmite suddenly triples in value because David Attenborough announces himself as a ‘lover’ not a ‘hater’, that £100 becomes £300. Assuming the rest of your portfolio stays the same, that means your shares now add up to £700, and your overall portfolio adds up to £1,200.
Are the shares still 50% of your portfolio? No. Now they’re closer to 60%, with your bonds and cash making up the other 40%. To get back to your planned balance, you need to either sell some shares (making profit on the increased value) or buy more cash and bonds.
So what’s the point? I thought growth was a good thing!
Of course it is. But you don’t want to end up like a bodybuilder with giant arms and tiny legs. When you originally set out your ideal balance, it was likely to mitigate the risk of having all your eggs in one basket.
If one of your shares is doing incredibly well – as in the Marmite example – your portfolio is now relying on it more. If it then experiences a sudden downturn, your portfolio will suffer higher losses by association. Better to reinvest some of the profits, diversify the portfolio, and spread out the risk.
Why else might you want to rebalance your portfolio?
Retirement is one of the most common times for investors to have a reshuffle. When you’re young, you can afford to invest in riskier companies (https://www.boringmoney.co.uk/ask/what-should-i-do-with-my-inherited-high-risk-investment-trusts/), knowing that over time you could potentially make more money. However, when it becomes likely that you’ll need to withdraw your money soon, as you would during retirement, it’s better to invest in less volatile companies, bonds or cash. You don’t want to be caught out with falling shares (https://www.boringmoney.co.uk/ask/sell-it-or-wait-for-the-fund-to-recover/) when there’s no time for them to grow again.
Of course, this has been a very watered-down look at portfolio rebalancing (unlike that punchy gin recipe), but hopefully by now you’ve got to grips with what it means and why it’s important.
Where should you go from here? Take a look at your portfolio, see if you’re relying too much on a small group of investments, and consider selling some of them to make way for others.
It’s worth noting that we can’t give you specific advice about your individual portfolio, so if you would like some help then it’s worth following these steps to find a good financial adviser.