Over time, certain investments might outperform others, resulting in an allocation that diverges from your original investment strategy. By rebalancing, you can maintain alignment with your objectives, thereby mitigating risk and potentially enhancing returns.
But what is the right way to rebalance your portfolio?
Three Main Portfolio Rebalancing Strategies to Follow
1. Time-Based Rebalancing
The frequency of rebalancing can significantly impact your portfolio’s performance and risk. Time-based rebalancing portfolio strategies involve adjusting your portfolio at set time intervals, regardless of market conditions.
For example:
- Monthly rebalancing. This approach ensures your portfolio stays very close to your target allocation. It's particularly useful in highly volatile markets where asset values can change rapidly. However, the downside is the potentially higher transaction costs and tax implications due to frequent trades.
- Quarterly rebalancing. A quarterly schedule strikes a balance between keeping your portfolio aligned with your targets and minimizing costs. It's less time-intensive than monthly rebalancing and still effective in managing risk.
- Annual rebalancing. Rebalancing once a year is the least time-consuming and often has lower transaction costs. While it allows more time for assets to drift from their original allocation, it's generally sufficient for most long-term investors and aligns well with annual financial reviews.
2. Drift-Triggered Rebalancing
Drift-triggered rebalancing is a strategy where you monitor your portfolio and act when its actual allocation diverges noticeably from your target allocation. Commonly, investors set this threshold at either 5% or 10%, but these numbers are not fixed and can be adjusted according to your individual strategy and comfort level. This flexibility allows you to manage transaction costs and taxes while maintaining a balance in asset allocation.
For example:
- 5% Threshold. In this scenario, you apply drift-triggered rebalancing by setting a 5% threshold. This means you would rebalance your portfolio whenever any asset class diverges by more than 5% from its target allocation. This tighter threshold keeps your portfolio more closely aligned with its intended risk level but may lead to more frequent trades.
- 10% Threshold. Here, the strategy is similar, but the threshold for action is set at a 10% deviation from the target allocation. This wider margin means rebalancing occurs less frequently, potentially resulting in fewer trades and lower transaction costs, but allows for a greater variation in asset allocation before rebalancing is triggered.
That said, choosing a threshold for a drift-triggered portfolio rebalancing strategy depends on your own preferences. Your aim is to strike a balance between maintaining your desired risk level and minimizing transaction costs and taxes.
3. Never-Rebalanced Strategy
While it's not connected with any actions, this "never-rebalanced" is also a strategy to consider. It involves setting your initial asset allocation and then leaving your portfolio to grow unchecked without making any adjustments.
- Pros. This approach has the lowest cost in terms of transaction fees and taxes, as it involves no trading. It's also the least time-consuming since it requires no ongoing management.
- Cons. Over time, your portfolio can drift significantly from its original risk profile. This drift could result in underperformance in certain market conditions and might not align with your original investment goals.
Conclusion
When you choose the best rebalancing portfolio strategy that matches your needs, it's crucial to weigh the costs, time investment, and tax implications against the benefits. Transaction costs and potential capital gains taxes can diminish the net benefit of rebalancing.
By understanding the best portfolio rebalancing strategies and their implications, you can make informed decisions that align with your long-term financial goals. Regularly reviewing and adjusting your portfolio can also lead to more effective investment management and better financial outcomes.
Wishing you a fruitful and profitable investing journey!
