What is portfolio rebalancing and why is it necessary?
When you build an investment portfolio, it will usually include a mix of different types of assets like equities and fixed income. Your investment risk tolerance determines the amount of each asset in the mix.
Over time, the value of these assets can increase or decrease in value. If they change enough, they can throw off amounts of each asset in your portfolio (also known as portfolio drift). This can expose you to more investment risk or less growth than you intended.
Portfolio rebalancing corrects portfolio drift, bringing your investment mix back to the asset amounts in your original investment plan. It’s as important as creating your asset mix in the first place.
When you should rebalance your portfolio
There are several times to consider rebalancing:
Regular portfolio reviews
The asset types in your portfolio and how much each asset has changed in value, determines how often you may need to rebalance. It may be as often as monthly or quarterly, but it’s a good idea to do it at least once a year.
The 5% rule
Let’s say your original portfolio was meant to include 40% equities. Over time, because of either growth or loss in value, if the amount of equities increases to 45% or more, or 35% or less, this guideline suggests it’s time to rebalance back to 40%.
End-of-year tax preparation
If you want to use any investment losses in taxable investment accounts (not RRSPs or other registered accounts) to offset investment gains, you may choose to rebalance before the end of the year.
Why you should rebalance your portfolio
To match your risk tolerance
Your comfort with investment risk is one of the most important factors in choosing the mix of assets in your investment portfolio. Without rebalancing, you could be accidentally taking on more risk than you planned to. This is especially important as you approach retirement (when most people reduce the amount of risk because they’ll be using that money soon).
To keep your target asset allocation
You set the amount of the different assets in your portfolio to align with your risk tolerance. When you rebalance, you’re staying true to your plan.
To stay on top of your investing
By regularly rebalancing your portfolio, you have to revisit whether your risk tolerance or your goals have changed. If not, rebalancing is reinforcing your original plan. But if something happens to change your life or priorities, and this causes you to question your original plan, you should change it.
When you don’t need to rebalance
If your investments consist of target date funds or target risk funds, these are automatically rebalanced by the fund manager on a regular basis.
If you’re a hands-off investor who doesn’t want to worry about things like rebalancing, target date funds or target risk funds are a great solution.
You may not need to worry about rebalancing if you work with an advisor who is taking care of the rebalancing for you.