Rebalancing 101: A Beginner’s Guide To Keeping Portfolio Risk In Check

Rebalancing 101: A beginner's guide

So you’ve built a well-diversified portfolio using an asset allocation that is tailored to your financial goals and investment objectives. But after a while you noticed that the asset classes start to deviate from your target asset mix.

What do you do? That’s where rebalancing comes in.

This post provides an overview of what rebalancing is, why it is important, the benefits of rebalancing and some tools available to rebalance a portfolio.

What Is Rebalancing?

Rebalancing is a portfolio management strategy that involves the selling and buying of different portions of a portfolio so as to bring it back to the desired or original asset mix.

In other words, the investor sells some of the winners and buys the losers. By doing this, rebalancing basically forces you to sell high (the overweight assets) and buy low (underweight assets).

It may sound counter-intuitive, but it is a disciplined approach to investing.

Related Post: What Is Asset Allocation And Why Is It Important In Investing?

Why Is Rebalancing Important?

Rebalancing ensures you are not taking more risk than you can tolerate in your portfolio.

Each of the asset classes in your portfolio will perform differently. After a while, your asset mix may be too far off from your plan, changing the risk profile of your portfolio in the process.

By rebalancing, you bring your portfolio back to a level of risk that can let you sleep more soundly at night.

Consider a starting asset mix of 60% in stocks and 40% in bonds. Let’s assume that stocks and bonds have average returns of 10% and 3% over 5 years respectively.

At the end of 5 years, the asset allocation would be 68% to stocks and 32% to bonds. That is quite different from your acceptable risk.

Example of rebalancing in action

And that’s the danger of not rebalancing.

How To Rebalance A Portfolio?

So how do you rebalance a portfolio that has deviated from your target asset mix?

Here are 3 options:

  • Sell the over-weight asset class: This is usually the quickest way to rebalance. You simply sell the over-weight asset and buy the under-weight assets. It is a good strategy if you’re investing in a non-taxable or registered account. For taxable accounts, you’ll need to consider the tax implications of selling an asset that has gone up in value.
  • Allocate new money to the underweight asset classes
  • Continue to allocate new contributions to all asset classes but with a higher weighting to the underweight ones.

There is no best way to rebalance – it depends on each investor’s personal circumstances. If you’re in the accumulation stage for example, adding new money to the portfolio may be a better alternative than selling one asset and buying another.

Adding new funds is also best if you need to rebalance in a taxable or non-registered account because selling the over-weight asset class will result in capital gains and be taxed.

On the other hand, an investor in the withdrawal stage that is not contributing new funds will need to sell the over-weight asset to rebalance.

Tools For Rebalancing

Depending on the number of individual securities you hold in your portfolio, rebalancing can be a quick activity or one that takes hours to complete.

Here are some of the portfolio rebalancing tools that are available to investors in Canada.

Rebalancing Spreadsheets

Spreadsheets are a quick and cheap way to get started with rebalancing. A google search will provide you with several options to choose from.

And the good part is, you can always customize the templates to fit your unique circumstances.

You can check out the calculator here from Justin Bender of CPM Blog.

Passiv

Passiv helps investors automate the rebalancing of their portfolio by linking to their brokerage account. It is a great tool especially for investors that need to manage their portfolio across multiple accounts.

The free tier of the service does all the rebalancing calculations, and the investor can place the trades through their brokerage.

But you’ll need to upgrade to the paid option ($99/year) to connect to multiple brokerages and rebalance across multiple accounts.

Fortunately, you can get the service for free if you’re a client of Questrade.

When Should You Rebalance?

Put another way, how often should you rebalance?

In general, you have two options: rebalance at regular time intervals or when the allocation to each asset class goes beyond a set threshold

#1. Rebalance at regular time intervals

With this option, the investor only rebalances the portfolio at certain time periods that have been previously set, such as monthly, quarterly, semi-annually or annually.

The investor simply sells the over-weight asset class and buys the under-weight class when the rebalancing date comes around.

#2. Rebalance at set thresholds

Rather than rebalance at a set calendar date, the approach here is to only rebalance if the current allocation deviates from the target asset mix by more than a set percentage.

For example: if the desired allocation to equities is 60% and the investor sets a threshold of 5%, the portfolio will be rebalanced only when the allocation goes below 55% or above 65%.

The idea here is this:

Rebalancing when your portfolio is only off by a few percentages is not worth your time and the cost.

#3. An hybrid of the two

Here, there is both a set time and threshold. For example, the portfolio will be rebalanced semi-annually but only if the allocations are off by more than 5%.

The advantage of this approach is that you won’t have to incur brokerage fees or spend unnecessary time on rebalancing when your portfolio allocation to an asset class is just off by a few percentages.

How Often Should You Rebalance?

How often you rebalance depends on a number of factors such as the portfolio size, how far away the portfolio is from the target asset mix, cost considerations and taxes.

Rebalancing is a risk management strategy. Yes, you need to minimize the risks in your portfolio but at what cost?

Each investor will need to strike a balance between managing portfolio risks and keeping investment costs (including time and effort) under check.

Here’s a recommendation:

Choose to rebalance annually (or semi-annually) but only if the allocations are off by more than 5%.

Do it too often and your investment costs may be too high; less often and you may end up with a portfolio that is vastly different from your target.

The important lesson here is to be consistent. Choose a system that works for you and stick to it.

Rebalancing and Asset Allocation ETFs

In theory, rebalancing sounds like a good idea. But if you have several securities across multiple accounts, it can quickly get complicated and cumbersome in practice.

With the advent of asset allocation ETFs though, investors now have another tool in their investment “toolbox”. By buying an asset allocation ETF, you can eliminate the need for periodic rebalancing of your portfolio.

The ETF providers automatically rebalance the ETF holdings for a modest fee.  For example, iShares asset allocation ETFs have an MER of just 0.20%. That is a great price for the convenience you get by investing using all-in-one ETFs.

Check here for a detailed post about how asset allocation ETFs work and how to start investing using them.

Conclusion

Rebalancing can often be counter intuitive. Why should you sell your winning investments and buy the losing ones?

But a big part of becoming a successful investor is being able to balance the risk you’re taking and the expected returns. Once your portfolio start drifting too far from your target asset mix, it is time to consider rebalancing.

What do you think? Do you rebalance or let your winners run? Let me know in the comments.

Related Post: How to start investing in Canada for Beginners

Simon is a CPA by day and a Personal Finance Blogger by night. With over a decade experience in financial services, he's passionate about personal finance, investing and helping people take control of their financial life.

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