Stay in Balance

In investing it is often the little actions that make a massive difference to how a portfolio performs over time. One of the “little” things that is so easy to ignore and put off is rebalancing the assets in a portfolio. In fact, many times question whether rebalancing is really necessary at all, and of course the answer is a resounding “YES”.

The easiest way to illustrate it is with an example, let’s use a fairly simplistic example: Consider a portfolio divided equally between Fund A and Fund B.

The reason we would want to balance different funds is to limit risk without giving up the return of well performing funds. Over a relatively short period of time there is a tendency for the best performers to build up too high a proportion of a portfolio as they increase in value more rapidly – meaning there is a lot more at stake if markets turn and suddenly that last great performer is sliding downhill fast.

So let’s say that our two funds had performance in the last year with Fund A being up 28.6 percent while Fund B lost 2.6 percent.

If we had started with a $10,000 portfolio split evenly between two funds at the start of the year, the portfolio would have grown to $11,300 by end of year. But by then 56.9 percent of the assets were in Fund A and only 43.1 percent in Fund B.

To rebalance, an investor would sell enough of Fund A to bring its balance down to $5,650 (half of $11,300) and invest the proceeds in Fund B.

Does rebalancing really matter? It certainly can over a longer period of time.

Imagine that same $10,000 portfolio evenly divided between these two funds and held for five years. After 4 years, without any rebalancing, 61 percent of the portfolio would be in Fund A and only 39 percent in Fund B. IF in the fifth year Fund A lost 9.1 percent and Fund B only 2.7 percent, the portfolio would lose $1,595 in Fund A and $307 in Fund B. Total loss: $1,902.

But if this portfolio had been rebalanced at the beginning of every calendar year the losses would have totalled only $1,683 in the fifth year. The investor who had rebalanced every year would have kept $219 more in 2000 than the one who didn't rebalance in earlier years.

There isn’t a lot to gain from lots and lots of rebalancing, but it is certainly something which should be looked at least annually for most investors. The key thing is to be aware that as some segments of investment markets – and your portfolio – do exceptionally well, there will be other parts going somewhat more slowly, and you do begin to increase the chances of bringing unnecessary risk into your investment portfolio.

Another consideration is transaction costs. Consider the cost to sell and the cost to buy. Many fund managers will let you "switch" from one fund to another within their stable for no cost.

Staying in balance is one of the smartest things you can do.