Most investors are really good at determining what type of asset classes they want to invest in based on the size of funds they have. These investors also are able to assess the risks that they could subject themselves to and steer in the direction best suited for them. However, one of the most common problems that I have noticed long term investors suffer from is sticking to the original plan, especially with re-balancing a portfolio.
What is re-balancing a portfolio mean?
Let’s first quickly talk about what re-balancing a portfolio means. When we are talking about re-balancing a portfolio, this is something that is required approximately every 12 months after finalizing an account. At this point in time some of the assets that you own may have increased in value with others decreasing in value. After the re-balancing period that you have selected has expired, it is up to you to review the account and buy / sell assets in order to return back to the original planned portfolio asset weightings. The process of performing this function is what we call re-balancing a portfolio.
What is the most significant factor that a re-balancing plan removes?
Re-balancing a portfolio is a major maintenance component of an investing plan. It’s really the only time that you are required to spend in order to maintain your investing account. The truth be told, it really doesn’t take that long to re-balance a portfolio and this is dependent on the total amount of assets that you own.
When you re-balance a portfolio you are balancing to hit the correct weighting that your portfolio is required to contain. This is very important as it removed the one factor that tends to destroy investors plans. That is emotion.
Emotion would tell us to sell of the assets that are diving in value. It happens this way as we are human. When something is not doing well, we want to do something about it. It is a natural human response. Likewise, when an asset is increasing in value, emotion would tell us to buy the asset as its doing well. This is a recipe for disaster and what a re-balancing plan would remove.
How Re-Balancing a Portfolio Works?
I’m sure you have figured it out by now. Re-balancing a portfolio does exactly the opposite as in the case above. It forces you to buy when assets are low in price and to sell when assets are high in price. Forcing you to buy low and sell high is the exact name of the game when it comes to making money. Choose to fight the impulse of acting emotionally when an asset booms and stick to your re-balancing schedule. This is one sure fire way to smooth out investments returns and maximize your growth.
A re-balanced portfolio vs non re-balanced portfolio – Which wins?
Considering a situation where you purchase assets and then just forget about them, this would nearly be a hands down loss in overall growth. Re-balancing a portfolio wins almost every time. As the market is more volatile with many bull and bear periods, the stronger re-balancing appears.
Example – How does Re-Balancing a Portfolio Work?
In the picture above, we have created a very basic/simple portfolio using real ETF’s and real market pricing at the times shown. The years between 2005 and 2015 have been selected in order to include the market and housing disaster of 2008. One of the first things you will see, is the portfolio dips at the end of 2008 and then bounces back a couple years later ending with some very strong growth.
During the majority of the graph, you can clearly see the lead that the re-balanced portfolio has. This lead starts nearly right away and continues right up until the end. The final dollar values over the course of 10 years is $151 651 vs $147 783. The difference works out to about 8% more growth.
Re-balancing a portfolio really shows its strength when there is market volatile. If the market had a long bull market stretch,(think 20 years) re-balancing would actually hurt growth. However, the key factor to remember is that these long drawn out bull markets do not exist. There will always be market volatility. Better yet, no one would ever be able to predict it anyway. Re-balance your portfolio!