The magic of rebalancing.
Of course, it feels good when you make a profit. Only if a certain category performs very well will the ratio grow skewed. The result of this is that you walk more than you actually want. To get your portfolio into the desired distribution, you need to rebalance.
What is rebalancing?
An investment portfolio is composed according to a specific risk profile. This determines the composition of the portfolio, or the ‘investment mix‘. The investment mix is the distribution of investments across investment categories, such as shares and bonds. A portfolio with 50% shares and 50% bonds has an investment mix of 50/50. In some periods, equities perform better than bonds, and sometimes it happens the other way around. The ratio of your investments can therefore grow unevenly. By rebalancing, you bring the composition and risk distribution back to the ratio you started with.
How does it work?
During rebalancing, investments that have performed relatively better over a certain period are sold. This means that part of the profit is taken and reinvested in investments that have performed less well.
Achieving extra returns with rebalancing
In this study from Morgan Stanley: https://www.morganstanley.com/articles/rebalancing-effect This article from Morgan Stanley (Engels) explains well how it works and what the effect of rebalancing can be. Based on historical figures, it has been calculated that rebalancing can
yield up to 1% extra return over a period of 20 years or longer. That doesn’t sound like much, but it can add up to a lot over a long period of time. Just look at the difference between 6% and 7% over 20 years.
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Calendar-based rebalancing:
This strategy rebalances the portfolio at predetermined intervals, regardless of the current state of the portfolio. For example, if you have decided to rebalance quarterly, semi-annually or annually, this will be done regardless of the current asset allocation. This approach is simple and easy to implement, but it can lead to unnecessary transaction costs if the portfolio is not significantly out of balance.
Rebalancing based on tolerance:
This strategy is more flexible and is only applied when the asset distribution exceeds a predetermined threshold. In your example, if the original 60/40 split is disrupted and becomes, for example, 50/50 or 70/30, rebalancing will occur.
This minimizes transaction costs, but requires regular portfolio monitoring to determine when rebalancing is necessary.
Conclusion
Rebalancing ensures fewer fluctuations, and can therefore also yield more!
Rebalancing will only take place when the deviation per investment category is greater than 5% (or higher) compared to the established investment mix.
Rebalancing, both calendar and tolerance based, is an important aspect of portfolio management. The aim is to maintain the original asset allocation and thus manage exposure to different assets within the portfolio.
Which strategy you choose depends on your specific goals, risk tolerance and preferences. Some investors prefer regular rebalancing to maintain strict control, while others prefer tolerance-based rebalancing to minimize unnecessary trades. It is important to know that rebalancing also costs money. Therefore, you will need to choose an approach that suits your investment objectives and strategies.
