Tip: Rebalancing your Portfolio

One of the most important parts of your investment portfolio is the crafting of an appropriate asset allocation plan that suits your particular situation based on your age, risk aversion, time horizon, and so on. This plan will create a structure for your portfolio and guide how you divide your contributions between investments. However, the weighting of your assets will change over time, which can be seen through the following example.

If you are properly diversified but are interested in a particular sector, you might have a portfolio like this:

• Diversified Stocks 40%
• Sector Specific Stock 20%
• Bonds 30%
• Cash 10%

The diversified stocks may further be divided into small-cap, medium-cap, and large-cap, or they may be made up of a few index funds invested in several markets, but for this example we'll keep it general.

Now, let's say you are heavily invested in the technology sector, which has just surged in stock price. This increase in value has altered your portfolio to look like this:

• Diversified Stocks 35%
• Sector Specific Stock 35%
• Bonds 25%
• Cash 5%

This might seem like a good thing; a large part of your portfolio has increased in value! However, if you compare this to the original asset allocation plan, it is quite different. To make up for this discrepancy, it is wise to sell some of the sector specific stock until the proper percentages are restored.

The same works when the weighting of an asset decreases in your portfolio. In this case, you will want to buy more of it to make up the lost value and keep your allocation as close to the plan as possible. As a rule of thumb,  it is recommended that if any instrument goes above or below it's allocation by 5% it should be rebalanced by either buying or selling.

In general, your asset allocation was created to suit your individual needs, based mainly on the time horizon for your investment and your risk aversion. If you cannot handle the ups and downs of the stock market, it is not wise to allow their weight increase relative to your other investments. Additionally, if a large part of your portfolio has become stocks and you are nearing retirement age, your investments may be much more volatile than you would like at such an age where time is not on your side.

The benefits may be more obvious if you consider the .com bubble at the turn of the century. At the time, many peoples portfolio were filled with technology stocks that were constantly growing in value and making up the bulk of their total investment. When the bubble burst, the ones who did not rebalance their portfolio saw a drastic decrease in their portfolio value, while those who did minimized the damages.

In the end, rebalancing will allow you to have a plan that you can stick to, but also avoid risking your investment when there is an impending bear market.  It is therefore a vital practice for those who have decided on a buy-and-hold strategy.