Michelle Perkins, January 2023

The concept of rebalancing your portfolio is a simple one. It involves buying and selling holdings in your portfolio to ensure allocations to the different asset classes align with your original asset allocation and tolerance for risk.

In reality, it is often difficult for individuals to rebalance as it means trimming holdings that have outperformed and buying holdings that have not performed as well. This is why it is important to understand the role the different asset classes, and rebalancing, play in a portfolio.

For example, the role of fixed income in a portfolio is to provide stability and certainty of income, while equities are held for capital and income growth. Rebalancing between the different asset classes, either annually or after big moves in the market, ensures that your allocations to these asset classes does not drift too far from your target allocation and that you are not unintentionally taking on more risk than you expect or are comfortable with.

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Rebalancing helps remove emotion from the decision-making process

When equity markets fall, taking the value of your portfolio with it, it can be very difficult for investors to view this as an investment opportunity. However, buying low and selling high are key tenets of superior prospective returns over the long-term.

Similarly, when equity markets are rallying, and your portfolio is delivering strong returns, you may question why you should trim the part of your portfolio that is performing well and allocate the proceeds to some of the laggards. The only problem is, markets overreact to both good and bad news, which in turn often causes the recent winners to subsequently underperform and vice versa.

It is therefore completely natural to sometimes be reluctant to rebalance. The risk is, however, that your portfolio drifts too far away from your target asset allocation and your tolerance for risk. Not rebalancing might be fine while markets are rising, but what about when markets unexpectedly fall 20%?

When this occurs, people quickly find that the volatility experienced is far greater than what they expected and are comfortable with.

A disciplined rebalancing strategy helps you to take advantage of situations in the market in a way that may feel counterintuitive at the time, but over the long-term have the potential to deliver superior risk adjusted returns.

Time compounds the drift away from benchmark allocations

If left unchecked, the drift away from your target asset allocation can continue to grow, leading to greater downside than anticipated during market corrections.

In the chart below we show the drift away from the benchmark allocation to growth assets for a balanced portfolio since 1997.

For investor A, who has a strategy in place to rebalance back to benchmark allocations every year, the maximum overweight exposure to growth assets throughout this period was 4.7%. This compares to a maximum overweight exposure of 15% for investor B who elected not to rebalance their portfolio throughout this period.

While implementing a rebalancing strategy means you may forgo some upside at times, the benefit of this approach can be seen below. During periods of major market corrections (the 2000-2002 tech correction, the 2007-2008 global financial crisis), periodically de-risking the portfolio by trimming the winners and buying the laggards saw the rebalanced portfolio significantly outperform.

And while you may expect investor B’s portfolio, with a higher allocation to growth equities, to have outperformed throughout this period, it is actually the rebalanced portfolio that provided superior returns along with a lower level of volatility.