Asset allocation helps balance return and investment risk by identifying a particular mix of investments based on an investor’s tolerance for risk. A portfolio might be divided into 60% stocks, 30% bonds, 10% cash, or a combination of both. The return on investment tends to increase the investment risk. Investors have the option to manage their risk by combining high-risk and low-risk investment options.
While investments are likely to increase in value, asset allocation can change. This is why it is necessary to rebalance an investment portfolio by selling investments and purchasing others. Otherwise, riskier investments may grow in value, and the investor might be unwilling to take on more risk.
But is it essential for a portfolio to be rebalanced? What are the pros & cons of rebalancing your portfolio?
Rebalancing has many advantages.
Asset allocations are designed to limit the potential impact of each asset type by limiting their upside and downside. However, if a particular investment gains in value faster than other investments, you may be exposed to greater risk than you intended. Rebalancing your portfolio allows you to return your investments to your original risk tolerance and decreases your portfolio’s chance of losing value.
Diversification is also improved when a portfolio is rebalanced. The portfolio’s performance will be affected if one stock is valued significantly.
Let’s suppose that you invested $10,000 in Tesla TSLA -2.8% Inc. on April 1, 2020, when it was around $100 a share and $10,000 into Intel Corporation INTC -4.4% when it was only $50 a share. These figures have been simplified to make it easier. You would own 100 shares TSLA shares and 200 INTC shares. TSLA traded at $688 apiece, and INTC was $65 apiece on April 1, 2021. Your TSLA shares are worth $68,800, while your INTC share is worth $13,000. Your portfolio would be more than 80% if you invested in TSLA.
Also, balancing prevents emotional interference from your buy or sell decisions. It can be difficult to twig to the advice to “buy low and sell higher” when selling winners to purchase losers. It is possible to resist selling stocks with significant gains in a taxable account. This is why rebalancing in retirement plans bills is more manageable, as the investor does not have to pay tax on capital gains.
Investment glide paths such as target-date funds that alter the asset allocation over time can cause rebalancing. As the target date draws near, investment glide paths decrease the portfolio’s risk mix. One example of a linear glide path is the old rule of thumb, which states that the percentage of stocks to be invested should equal 100 times your age. This reduces portfolio risk as the retirement age approaches. The portfolio should be re-balanced regularly to ensure that it follows an investment glide path.
The disadvantages of rebalancing
But why would you sell investments in an excellent performance to purchase investments that don’t perform well?
Continuing from the previous example: TSLA stock had risen by $1,145, and INTC stock was at $49 a share as of November 1, 2021. Your portfolio would be worth $98,899 if it were rebalanced on April 1, 2021. That’s about a fifth of the $124,000.300 that it would have been worth without rebalancing. The portfolio is worth more than the $81,800 it was worth in April but less than it would have been worth if it had not been rebalanced.
Rebalancing is a poorly thought-out strategy. It assumes that high-flying investments cannot go lower or that there is no growth potential. Because it has made so much progress so quickly, it believes that the value of the investment will decrease. The argument is that the portfolio must be rebalanced to prevent it from losing value.
Past performance doesn’t necessarily predict future results. Rebalancing can lead to investment decisions being based on past performance. It is a pessimistic type of market timing that is less effective than remaining invested.
Rebalancing assumes that stocks have a greater chance of losing value when they are valued higher. However, this is not always true. This assumption also takes that low-performing investments are hidden gems that will increase their value without supporting evidence. It is unreasonable to assume that an investment will not continue to exhibit poor performance if it has already shown poor results. Sometimes, a stock may be a poor performer due to a specific reason. If this happens, it is unlikely that rebalancing will improve its performance.
There are also common strategies like buy-and-hold or harvesting losses to offset a capital gain.
You should look ahead when deciding to rebalance. This should take into account future trends in the stock and bond markets. If your original reasons for purchasing the investment no longer apply, you should sell it.
It is not a good idea to sell stocks to purchase bonds. Bonds are more likely to decline in value as the Federal Reserve Board increases its interest rates. In general, interest rates and bond price movements are in opposition. A strategy to lose money is to sell an investment that is expected to increase in value and buy one that will decrease in value.
In the INTC and TSLA examples, both stocks are affected when demand exceeds supply. But, INTC is unlikely to outperform TSLA. Tesla’s market dominance means no incentive to include certain features that consumers would like, such as a heads-up display (HUD) and digital rearview mirrors. Tesla doesn’t face a shortage of its vehicles. Both INTC and TSLA are restricted in their ability to increase production speed to meet demand.
If an investment is volatile, moving up or down frequently, especially if gains and losses are out-of-sync with other investments, rebalancing can work well. When one investment outperforms all others, balancing is not a good idea.
If you have a long investment period, then rebalancing is not necessary. You can still recover from a short-term loss.
Due to the transaction fees associated with buying and selling regularly, rebalancing can increase costs. Rebalancing incurs additional fees and also raises taxes on capital gains.
Alternate to using percentages to rebalance. You could rebalance using the original investment in each asset class. This may be adjusted for inflation. The actual amount invested can be used as a safety blanket and maintains the same risk profile. These gains are only the icing on a cake.