Last Updated: October 18, 2021
The market activity is most times driven by macroeconomic conditions. Depending on the economic cycle, certain sectors or assets tend to perform better than others. The way you allocate assets in your portfolio has a direct impact on its performance and profitability.
As an investor, it is important to know how economic activity affects the performance of assets in your portfolio.
Such knowledge would enable you to balance your portfolio according to the prevailing macroeconomic trends and reduce the potential of loss on your investments.
This article highlights the benefits of portfolio rebalancing and how investors can optimize this strategy to achieve higher returns.
Portfolio rebalancing simply means readjusting your portfolio to achieve your investment goals and objectives.
It is the process of changing the weightings of assets in an investment portfolio to minimize risk levels. It is an active management strategy whereby an investor identifies potential risks in the market or flashpoints in his portfolio and tweaks the structure to align with predefined investment goals.
Investment decisions concerning portfolio rebalancing are based on market trends, economic forecasts, or mispricing in asset valuation. The focus of rebalancing is effective asset allocation which is aimed at optimizing portfolio returns.
Rebalancing can be done by either selling one investment and buying another or by allocating additional funds to either stocks or bonds.
When you first design your portfolio, you would want to maintain a structure to accommodate the identified risks in the market. This requires spreading your investment across different assets or sectors.
However, due to price fluctuations, these allocations don't stay the same, making your portfolio unbalanced. Depending on the performance of each asset, you would have to periodically add to or trim your position.
For example, you may want to maintain a 70-30 structure for your portfolio in the next 10 years. This entails having 70% of your portfolio in stocks and 30% in bonds.
However, you discover that the stock has risen by 30% in 5 years, thereby making your portfolio overweight on stocks. You can rebalance by reducing taking your profits from stocks and investing in bonds or other assets.
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The major reason for rebalancing a portfolio has to do with fluctuations in the prices of assets. As the price changes, this affects their valuations. If the price increases, an asset can be overweight in a portfolio.
On the flip side, if the price falls, an asset can be underweight in a portfolio. Both conditions have an impact on the overall performance of your portfolio. An overweight asset can drag or uplift a portfolio because it has a greater impact on its performance.
Portfolio rebalancing can also be done to take advantage of opportunities and boost returns on your investment. Perhaps you noticed a mispriced valuation and want to take advantage of the opportunity before the market comes around.
You may decide to trim your position in some assets to fund and exploit opportunity in other assets.
Rebalancing your portfolio allows you to maintain your desired level of risk over time.
If you are overweight in a stock or asset, this exposes your portfolio to more risk which could impact your portfolio. Rebalancing ensures that you maintain the ideal portfolio mix that would taper the risks from the market.
Here are some tips on how to rebalance you can consider.
To effectively rebalance your portfolio, you need to understand how the economic cycle has an impact on the performance of assets.
For example, certain assets such as gold, energy stocks, and REITs tend to do when during economic inflation. On the flip side, these assets perform poorly during a recession.
An understanding of the prevailing macroeconomy cycle would let you know how to allocate investments in your portfolio.
Rebalancing your portfolio goes beyond just selling or adding to a position.
You need to have an understanding of effective asset allocation. You may decide to reduce your position in an asset only to allocate the resources to a non-performing asset. While you may have prevented a loss, your investment action may have also affected the returns you would get.
As such, you need to understand how assets are correlated to each other.
Some assets are proxies, that is they track a sector or an underlying asset. Others are inversely correlated, that is a movement in one asset, leads to a negative reaction in another.
An asset weight is the percentage of the asset in relation to the overall portfolio. You can determine the weight of an asset by dividing its value by the total value of the portfolio. Having a well-balanced portfolio means that the assets have equal weight.
However, this may not be obtainable in all cases. Sometimes, an investor may decide to maintain an unequal weight across assets in his portfolio. This may be due to price, volatility, or investment goals.
Setting weighting parameters for assets in your portfolio can enable you to know when the portfolio is out of balance.
You can rebalance your portfolio by dollar-cost averaging (DCA). This is an investment strategy whereby an investor buys more of an asset when there is a drop in its price. This reduces the average cost of investment in that asset. Using DCA is a way of balancing underweight assets in a portfolio.
This is an expression used to describe the continual repetition of an action or sequence of events.
In investing lingo, it means selling at the top and buying back at the bottom.
This is a trading strategy that seeks to profit from the cyclical pattern of a stock’s movement. Rebalancing your portfolio with this method entails tracking the price action of selected stocks and taking appropriate action. The investor buys when the stock price is low and sells when it is high.
This is a short-term portfolio rebalancing strategy.
Portfolio rebalancing is mainly a risk management strategy.
However, if done effectively, it can be used to boost profits There is no perfect method of determining your ideal strategy for rebalancing a portfolio.
It depends on your investment goal, experience, and risk appetite. The key is understanding the cycles in the market and knowing how to appropriately allocate investment across assets.
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March 23, 2023