Ideal Asset Allocation: Portfolio Rebalancing

Portfolio rebalancing is something that every investor should do regularly. In order to minimize the risk of your portfolio and increase potential returns, you need to regularly rebalance your portfolio. Here are the basics of portfolio rebalancing and why it is important.

Unbalanced Portfolio

When most investors get started with a portfolio, they try to create the ideal asset allocation for their situation. For example, they might invest in 60 percent stocks and 40 percent fixed income securities. They might have the idea of sticking with that allocation for the long-term. The only problem is that over a certain amount of time, the portfolio can become unbalanced. Many investors do not understand how this works until they take a deeper look at it. If you invest 60 percent of your money into stocks, the value of these stocks is going to change over time. Some of them are going to increase in value while others decrease in value. If your stock holdings increase in value substantially, this is going to increase the percentage of your portfolio that is made up of stocks. You might find that 65 percent of your portfolio is now stocks while only 35 percent of your portfolio is made up of fixed income securities.

Why Rebalance?

It is important to rebalance your portfolio whenever it becomes unbalanced. Even though you might think that it is a good thing that your stocks increased in value, you should still sell some of them and put the money into fixed income securities to become rebalanced. Stocks are going to move up and down in price. When they move up, it is important to take out some of that profit and move it into a more secure investment. This is going to ensure that your portfolio continues to grow according to the asset allocation percentage that you set forth.

How to Rebalance

The process of rebalancing is simple. You will need to sell the security that is making up a bigger percentage of the portfolio then it should. You will then take that money and use it to purchase more of the type of security that has less than the percentage that it should.

What Could Happen

Some investors think that it is unnecessary to rebalance your portfolio periodically. If you ignore the importance of rebalancing your portfolio, it could come back to hurt you severely. For example, let's say that you had the portfolio from the above example with 60 percent stocks and 40 percent fixed income securities. Over a period of several years, you might find that the stocks that you chose declined in value. When this happens, the value of your portfolio could plummet significantly. If you had rebalanced your portfolio periodically, you would have been taking money from the fixed income securities and used it to purchase shares of new stocks. Those stocks may not have suffered the same ill fate of the ones that you initially chose. Portfolio rebalancing can help you get through bad investment decisions like this. 

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