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Question: What is portfolio rebalancing and why is it important?
From our Investment Manager, Deirdre Rooney:
A survey of over 25,000 investors in 32 countries showed that typically 70% would make changes to their portfolio during periods of market volatility. Unfortunately, the changes they made left 51% of them unhappy with the results. Managing a portfolio isn’t easy — it’s a dynamic process that responds to change in financial markets. Rebalancing is an important part of that process which aims to maintain a desired asset allocation.
The mix and quantity of the different investments in your portfolio is referred to as the asset allocation i.e. how much of your portfolio should be invested in a particular asset. It’s important because over 90% of the returns obtained over time come from the allocation of assets within your portfolio. (see: Should I wait to invest at the bottom?)
Spreading your portfolio of investments across a variety of markets that respond differently to factors such as economic growth or contraction, inflation, and interest rates, reduces your risk of loss: You don’t have all your eggs in one basket.
But it’s important to stick to your asset allocation so that your portfolio doesn’t become more or less risky than you want. Too much risk in your portfolio means you may face higher losses than you can afford. Too little risk and you won’t see the growth you need to reach your investment goal. Imagine driving to a friend’s house along a road with lots of hills and bends. If you drive much faster than the recommended speed limit, your risk of an accident is increased. But if you drive slower than the speed limit, it’ll take longer to arrive.
Let’s look at an example: suppose you start with an investment of £1,000. The portfolio that matches your risk profile is made up of two assets: a stock and a bond in equal amount i.e. a 50% allocation of £500 to each asset. After 1 year, the stock has performed well and risen 20% but the bond hasn’t changed. The value of stocks in the portfolio is now £600 and bonds are unchanged at £500. Your portfolio asset allocation is changed to 55% stocks and 45% bonds.
If global stocks were to fall suddenly, your portfolio has a higher risk of loss than before because your allocation to stocks is greater than the original 50% allocation: You’ve now got more to lose in a stock market decline. To get back to your original allocation of 50% / 50%, you simply sell some stocks and buy some bonds. This activity is called rebalancing.
There are several important benefits that come from regular portfolio rebalancing:
- Rebalancing is a form of risk management. Risk is a driver of returns from your portfolio and therefore it requires management. In the example above, rebalancing reduced the risk of loss in the stock asset and therefore reduced the overall risk of the portfolio. How often you rebalance depends largely on the costs of doing so because such costs eat into your returns. We recommend you check if your investment manager charges you for rebalancing. However, research suggests that in times of volatility, such as we’ve recently experienced due to the coronavirus, rebalancing more often gives better returns.
- Prevents emotional decisions and behavioural biases. Everybody has biases: we make judgements about people, opportunities, government action and financial markets. We view the world through the lens of our own experience and knowledge which results in bias — an illogical preference or prejudice. Behavioural finance researchers have identified several investor biases which usually lead to selling at market bottoms and buying at tops. Financial market history has documented several bubbles and manias that provide useful insight into such irrational investor behaviour. Rebalancing your portfolio leads to “good” investor behaviour and discipline.
- Rebalancing typically reduces assets that have outperformed and increases assets that have underperformed. In this way, rebalancing harvests capital gains (see our response on portfolio taxes) by selling outperforming assets to keep their allocation at the right level. This enables you to make use of your annual capital gains allowance which expires each tax year if not claimed. As an example, imagine you had a portfolio that grew in value by exactly £1,500 each year. You held this portfolio for ten years so you’ve made a capital gain of £15,000. When you sell this portfolio today, you realise a capital gain of £15,000. After deducting your capital gains allowance of £12,300, you will pay tax at a rate of 20% on the amount in excess of your allowance or £540. Had you used prior year allowances, there would be no tax to pay. The larger your portfolio becomes through capital gains, the greater your need for a suitable tax strategy.
Please note that the information provided in this response is of a general nature. It is not a substitute for specific advice in your own circumstances. You are recommended to obtain specific professional advice from a professional accountant or tax adviser before you take any action regarding your tax situation or refrain from such action.
Keep an eye out — more questions and answers to come! In the meantime, submit your question here and we’ll make sure to respond.
