Archived article: Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.
Having a balanced portfolio is a widely accepted strategy for creating solid returns for your investments without taking too much risk.
The goal of balancing a portfolio is simple: create a diversified portfolio that isn’t overly exposed to any single element, so you can ride out market dips with a little less stress. But how exactly to go about balancing is a mix of art and science and requires a bit of inward thinking before you can start making decisions.
When an investor is first setting up their portfolio, they are usually asking themselves some basic questions, like how much risk they are comfortable taking and what goal they are trying to achieve. Then, they can establish how much of their portfolio they will hold in different assets. A risk-averse investor may choose to hold a larger proportion of bonds or money markets, while a more adventurous investor could lean heavily on equities. However, once those initial investment decisions are made, the job isn’t necessarily done.
Why rebalancing matters
As the investments grow, they will likely change proportions from what you originally set. For example, if you begin with a portfolio that is 60% equities and 40% bonds, but the equities do much better than the bonds, your portfolio may turn into 70% equities and 30% bonds by the end of the year. This is where rebalancing comes in because now, you are taking more risk than you originally intended. While it’s paid off so far since the equities have risen in value, it’s now time to decide if your original investment philosophy still stands, or if you want to let the investment run.
One of the key things to remember at this point is what you set out to do: you are creating a portfolio, not a collection of ideas. Although you may be giving yourself a pat on the back for choosing the assets that are going up, think about what purpose you are really looking for the portfolio to serve. If it’s funding your future house, or your child’s education, you likely want to exercise a bit of caution.
Pulling the trigger on a rebalance
The uncomfortable part of rebalancing is also why it works. You trim the winners which have become a larger portion of your portfolio and buy more of the part that hasn’t done as well. This feels painful at the time, but it makes sense in the long term.
As long as your financial goal has stayed the same, going back to your original proportions helps to keep you at an appropriate risk level. And by purchasing more of an asset that hasn’t performed as well, you could be buying in at a more attractive valuation, likewise by trimming strong performers you could be stepping away from crowded trades that have less upside ahead of them and locking in gains.
You also aren’t completely abandoning the asset that has done well, just scraping a bit of the cream off the top. Once you rebalance, you’ll be back to the original allocation level not zero, so if it does go up again, you’ll still benefit.
How to know when to rebalance
There are two main strategies used for determining when a rebalance is necessary. The most straightforward is simply on a calendar basis. This could be quarterly, semi-annually, or annually. At each interval, you would readjust your holdings to the original proportions. Usually, adjustments are only made at a certain level, for example if there is a 10% difference from the original proportions. If you rebalance for every small deviation, you could face additional trading costs that eat into the gains.
The other method is a triggered trade. This means that the rebalancing occurs when an investment reaches a certain threshold proportion. For example, if you began at a 60% equity holding, your threshold may be 75%. If this threshold is hit, you then make your trade.
Whichever strategy you choose, it’s important to follow your own rules. Not letting the excitement of an investment get the best of you is key to effective rebalancing.
Does rebalancing work?
Putting an emphasis on rebalancing may seem strange when another maxim of the markets is to ‘invest and forget’. This is a very effective strategy for those who have an investment horizon that stretches over decades and are comfortable with their assets in equity.
In reality, many of us will need to access that money in the not-so-far future, whether it be for retirement or another purchase. Here, the metric that becomes useful is looking at risk-adjusted returns, which factor in elements like volatility. A study by Wellington Management measured the risk-adjusted return of different rebalancing strategies against one where the portfolio allocation is allowed to drift wherever the performance takes it. While different rebalancing strategies all gave a ratio of annual return versus volatility of about 0.85, the drifting portfolio's risk adjusted return sat at closer to 0.75.
Letting the professionals do it for you
Not everyone will want to deal with the difficulties of rebalancing. Fortunately, there’s plenty of funds that will do it for you. You can take a look at AJ Bell’s funds, which allow you to pick from a range of options with different risk levels. Then, the investment team does any rebalancing for you to manage different asset classes, as well as different regions.
Ryan Hughes: Managing Director of AJ Bell Investments
Ryan Hughes is AJ Bell's Managing Director of AJ Bell Investments. He joined AJ Bell in 2016 as Head of Fund Selection before moving on to become Head of Investment Partnerships and later, Investments Director...
