The target mix of your investment portfolio should be built on your goals, time horizon and risk tolerance. But goals can change, and market fluctuations can cause your asset allocation to shift, so it’s important to monitor your portfolio on a regular basis and make adjustments as needed to ensure you are not taking on more risk than you are comfortable with.
This process is called portfolio rebalancing.
When should investors rebalance?
Most rebalancing strategies consider two types of triggers: time, threshold, or a blend of both.
With a time trigger, the portfolio is rebalanced on a predetermined schedule such as quarterly, semi-annually or annually (but not daily or weekly).
With a threshold trigger, the portfolio is rebalanced only when its asset allocation has drifted from the target by a predetermined percentage, such as 5 or 10 per cent.
How can investors rebalance?
1. Reinvest dividends
Direct dividends and/or capital gains distributions from the asset sector that exceeds its target into one that is underweight.
2. Make additional contributions
Add funds to the asset sector that falls below its target percentage.
3. Transfer funds between asset classes
Shift money out of the asset class that exceeds its target into the other investments.
When you rebalance you need to consider the costs and tax implications. In most cases you will have brokerage costs and, with some managed funds, an entry/exit fee. There may also be tax consequences when transferring funds between asset classes. Sometimes it is more tax effective to use new cashflow or distributions rather than transferring assets.
If you have a large portfolio, redirecting cash flow or dividends may not be sufficient to bring your asset allocation back into balance. In such instances, you might have to liquidate investments to rebalance, which may have tax implications.
How often should investors rebalance?
Generally, more frequent rebalancing will ensure tighter tracking to your target asset allocation, but this potentially comes at the cost of lower returns, increased turnover, and a heavier tax burden in the current period. This is why rebalancing should not occur on a daily or weekly basis.
Vanguard research has found that there is no specific rebalancing threshold or frequency that consistently outperforms. Rather, an investor’s rebalancing strategy is based on their willingness to accept risk against their expected returns.
Research has also shown that any rebalancing is better than not rebalancing at all.
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