After a year of double-digit stock market returns, it may be time to rebalance your portfolio.
This will ensure that you are not deviating from your long-term investment plan.
It is a good idea to do a detailed analysis of your portfolio at the end of the year or the beginning of the calendar year. Let us discuss the process in detail.
Why is rebalancing required?
In general, stocks are the most preferred asset class for capital growth, while fixed income securities are often used for the primary purpose of preserving capital.
The strong stock market performance in 2021 has most likely caused many investors to leave their target portfolio allocations.
The goal of the allocation is to balance different risks while working towards long-term goals by targeting a certain percentage of your portfolio to invest in different asset classes mainly stocks and fixed income.
In a year when stocks outperform fixed-income securities, a portfolio rebalancing is necessary to shift some of the wealth creation from the equity portion of the portfolio to the equity portion of the portfolio. Fixed income of the portfolio to preserve the newly created wealth.
How has the asset structure changed?
Consider an example where the portfolio is 60% stocks and 40% fixed income. Again, in stocks, you have a 35% large-cap, 17% mid-cap, and 8% small-cap.
Assume that large-cap, mid-cap, and small-cap stocks have gained 43%, 70%, and 103%, respectively, over the past year.
As a result, your targeted asset allocation would go from a 60:40 mix of fixed income to stocks (36% large-cap + 21% mid-cap + 12% small-cap) and 31% in debt.
To get back to your target 6040% asset allocation, you need to use portfolio rebalancing, which means you need to sell some stocks and invest more in fixed income.
Benefits of Portfolio Rebalancing
Typically, investors choose their portfolio to have a predefined asset allocation based on their financial goals with the right level of risk. As markets fluctuate, the weights can deviate from their original preferences.
In general, over the long term, stocks tend to outperform bonds. And if rebalancing isn’t done periodically.
It’s more likely that the portfolio will start to lean more toward stocks. As a result, this can expose investors to additional risk during times of volatility, with the potential for larger losses in the future.
So rebalancing will bring the portfolio back to your original asset allocation.
This can be done in two steps. In the first step, determine the total investment at the target rate, and then calculate which assets should be bought and sold and in what quantities.
In conclusion, an investor needs to ensure that his/her portfolio allocation remains within his or her risk tolerance and that rebalancing should be performed periodically, at least once a year, to ensure that market activity does not skew portfolio allocation too far from targets..
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