How to rebalance your portfolio to stay on track

I keep hearing the term “balanced portfolio”. What does it mean, why is it important and how do I do it?

 

These are all questions people don’t typically think about when they start investing their money. They focus primarily on the investments themselves; buying low and selling high. But what most people don’t realize is that rebalancing your investments can actually make you more money! Here’s the what, why and how.

 

What does rebalancing mean? Case Study

 

When you invest, whether it be stocks, ETF’s, bond’s, etc, over time some of those investments will naturally perform better than others. In order to ensure we buy low and sell high we “rebalance" once per year to cash-in profits on the winners, and invest more money into the stuff that didn’t perform so well.

Think about it this way: every investment is like a rolling wave, moving up and down, some more quickly than others. Now, it’s impossible to predict the future and know exactly when each wave will hit its peak or bottom, so when one of our investment waves has risen fairly high it makes sense to take some money off the table and put it into the other investments who's waves have not yet peaked.

Surf's Up!

Surf's Up!

In my guide Building a Bulletproof Portfolio, I talk in depth about asset classes and allocations, but here are the basics to get you started. 

 

How do I rebalance my investments? Case Study

Let’s pretend on January 1st we buy two ETF's – ETF ABC and ETF XYZ, each costing us $10 per share. We put equal amounts of money into each; let’s say $500, giving us a 50/50 split.

$10 per share divided by $500 into each ETF would give us 50 shares of each. 

The year goes by and on December 31st ETF ABC has done really well and is now worth $15 per share, but XYZ hasn’t been so hot and is only worth $9.50 per share. We’re now up $250 on ABC (50 shares x $5 profit per share), and down $25 on XYZ (50 shares x -$0.50 per share).

 

The value of each of our investments now looks like this: 

  • ABC value = $750 (50 shares x $15 per share)
  • XYZ value = $475 (50 shares x $9.50 per share)

 

As you can see we no longer have a 50/50 split; we are “off balance”. We now need to “rebalance” our investments. We can do this one of two ways: 

 

  1. Rebalance with cash, meaning to invest more money and bring the total dollar value of XYZ up to $750, or;
  2. Rebalance by selling $250 worth of ABC, bringing its value back down to $500, and then investing $25 from the profits into XYZ, bringing its value up to $500. 

 

As you can see this is fairly straightforward, but if you have more questions I'm happy to answer them in the comments below. 

 

Should I rebalance using cash or by selling my winners?

Personally, I always try to rebalance with cash. Here's why:

Firstly, I’d hate to sell a winner in case it has more room to run. Instead, I’ll place a trailing stop on my winners to protect profits – I explain this in How to Make Money in the Stock Market Just Like the Pro's. Secondly, there's a commission fee every time we buy or sell, so rebalancing with cash cut’s my brokerage fees in half.

If you simply don’t have the extra money laying around to rebalance with cash that’s OK. By making a $250 profit on ABC and only having to reinvest $25 of it into XYZ will leave us with a cash reserve of $225 which we can use to rebalance with cash in the future. 

 

How often should I rebalance?

Don’t worry if things start getting off-balance only a few months into the year.

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If you have extra cash available to invest you can continue rebalancing throughout the year by investing it into the lesser performing investments. At a minimum, rebalance at least once per year and you’ll be fine.

If something major happens and one of your stocks goes through the roof you can rebalance every six months.

 

Why should I rebalance my investments?

The first reason is to control risk and protect your money from getting wiped-out in a market crash, and secondly, to ensure you buy low and sell high

Let’s pretend your investment portfolio consists of 40% fixed-income (safe stuff like bonds, cash, and preferred shares), and 60% equities (stocks and index ETF’s). Because equities are more volatile than bonds they will move up and down more frequently, and in greater value.

If the stock market has a great year and your equities grow substantially, you want to protect some of those profits in case the market reverses and comes back down.

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Alternatively, if the market crashes, your equities will go down, but your fixed income stuff will rise, giving you the opportunity to cash-in profits on your fixed income investments and then reinvest those profits into your lagging equities. When the market recovers you’ll make money hand over fist! 

 

How often do you rebalance your portfolio? Let me know in the comments below


Disclaimer: The views expressed is provided as a general source of information only and should not be considered to be personal investment advice or solicitation to buy or sell securities. Investors considering any investment should consult with their investment advisor to ensure that it is suitable for the investor’s circumstances and risk tolerance before making any investment decisions.


Before you invest be sure to download your free copy of Building a Bulletproof Portfolio, the complete guide on how I built a winning portfolio that sailed through the 2008 stock market crash without losing a dime.