There will be times when you need to rebalance your portfolio.
That means, putting it back to the asset allocation you intended.
But, what is an asset allocation anyway?
In layman’s terms, this is your strategy for balancing investment risk with potential reward so it aligns with your long term investing goals. (Not to be confused with asset “location” – where you can hold your assets – usually for certain tax advantages.)
First, let’s define these terms briefly.
More on asset allocation
When you hear the term asset allocation think of the three main asset classes most investors hold:
- bonds, and
As investors we want to combine investments that belong to those asset classes intelligently to:
- reduce investment risk (the potential to lose money), and
- increase investment return (the potential to make money).
You can therefore allocate assets – spread them around – in various percentages to strike your desired balance.
There is no one-size-fits-all asset allocation formula for all investors.
It’s up to you to decide what is right for you.
What is rebalancing?
Simply put, rebalancing is the process of realigning the mix of your assets (stocks, bonds, cash) back to match your investing goals.
Think of it in terms of your car. You typically rebalance the tires every time you get new ones installed. That way you’re not driving down the road towards your destination in a risky way. Same goes for your money.
Rebalancing can occur in a number of ways. I’ll highlight two main ones I’ve used:
- buy more assets – without selling other assets – to get more of what you want.
- sell existing assets – and use those proceeds – to get more of what you want.
The term "rebalancing" may imply you need an equal distribution of assets. (For example: 33% stocks, 33% bonds and 33% cash.) But, you know from our asset allocation definition above that’s NOT true at all.
Why? Because the mix of your assets is up to you.
Three things come to mind for me:
1. Get your portfolio back to your desired mix
You rebalance because stocks and bonds and cash all behave differently when it comes to their long-term performance over time, as they relate to market conditions and inflation-fighting power.
2. Align your changing financial needs
You rebalance because your needs change over time.
You will age. Your investing goals may change. You have different priorities when it comes to your money and what you need it for, including when you will spend it.
Rebalancing is a way to adjust your risk and reward. It gives you a much better chance of meeting your financial needs.
3. Increase your returns
You rebalance because studies show it can increase your returns without taking on more risk.
You can buy more of what you need, to get your balance back in check, at a low price. You can ride returns as stocks or bonds increase in value over time.
How do I rebalance my portfolio?
Over the years I’ve considered and experimented with the following:
1. Rebalance by time
This is easy. Pick one month a year – I used January for many years. Then, use that time to buy or sell assets to rebalance the portfolio every year without fail.
2. Rebalance by targets
This one is a bit trickier and can be more frequent. You choose to buy or sell assets based on small (or modest) gains or losses in your portfolio – say swings of +/- 5% or 10% or more. I’ve never really been a fan of this method because you have to monitor your portfolio more. It could also entice you to trade more than you should.
3. Rebalance by adding more cash and investing at certain times
The indexing guru’s from Vanguard call this their “time-and-threshold” strategy. You can read more details about their approach and excellent rebalancing practices here.
What do I do today?
I use approach #3 above each year with some nuances.
Every year we strive to max our Tax Free Savings Account (TFSA) contributions. Those accounts hold Canadian dividend paying stocks. Each year, we purchase stocks that we believe are:
- reasonably priced, and
- aligned to the sector breakdown of the TSX Composite Index.
For example, take the iShares ETF XIC product. A popular product with many index investors. The TSX Index (and XIC) has a breakdown of roughly:
- 35% financials (think banks and life insurance companies),
- 20% energy (think Enbridge, Suncor, Canadian Natural Resources and more),
- 12% materials (think mostly mining companies), and
- a lesser amount of industrials, telecommunications companies and Real Estate Investment Trusts (REITs).
So, every January after TFSA contributions are made, I look to Canadian dividend paying stalwarts in these sectors to buy and hold going-forward.
When it comes to other accounts, it’s a different story. I actually don’t worry about rebalancing assets in our RRSPs (Registered Retirement Savings Plans) very much.
For two main reasons:
- those accounts have more indexed products in them – mostly U.S. and international equities;
- I also don’t hold any bonds in those accounts. (I tell you the reason right here.)
That means I have little rebalancing work to do inside our RRSPs. There are no bonds to buy or sell, just equities to buy after enough cash builds, usually 3-5 times per year.
The only thing I really monitor is the balance between the Canadian content of our portfolio versus the U.S. and international content held. For that, I’m aiming at 50/50.
How to rebalance your portfolio?
I don’t think there is a perfect rebalancing recipe for you, but I do think rebalancing is an important activity.
Here are 5 points to consider:
- Rebalancing is admittedly more challenging with individual stocks than with a single fund for each asset class. Based on the design of our portfolio, I need to consider imbalances between my individual holdings more than an index investor.
- Be mindful of the number of transactions you make to rebalance your portfolio. More purchases mean more commissions. High fees are bad when it comes to investing. Fees are lost money forever.
- Although I love reinvesting dividends, consider stopping DRIPs so the cash portion of your accounts can build up over time. Then, use that cash to rebalance your portfolio with new purchases.
- When possible, try and rebalance your portfolio through buying more assets instead of selling first and then buying more. I believe the longer all money is invested and working for you, the better. You also have one less transaction fee to worry about.
- Time-based rebalancing helps avoid investor panic. Investor behaviour is a key ingredient to financial wealth – something I continue to work on myself. Although big market corrections can be a great time to rebalance your portfolio, your emotions might get in the way of good decision-making.
Some final thoughts
Last year was a great year for equities… but the strong performance of the stock markets is never guaranteed.
Fortunately, we can control some of that risk by setting an appropriate asset allocation and then following a sound rebalancing strategy to keep things in check.