Why you need to rebalance your portfolio

By Odhiambo Ocholla

Portfolio rebalancing is the process of bringing the different asset classes back into proper relationship following a significant change in one or more.

More simply, it is returning your portfolio to the proper mix of stocks, bonds and cash when they no longer conform to your plan.

Alternatively, rebalancing is the process of buying and selling portions of your portfolio to set the weight of each asset class back to its original state.

In addition, if an investor's investment strategy or tolerance for risk has changed, he or she can use rebalancing to readjust the weightings of each security or asset class in the portfolio to fulfil a newly devised asset allocation.

It is normal to establish an asset allocation strategy that is right for you, but at the end of the year, you find that the weighting of each asset class in your portfolio has changed.

Over the course of the year, the market value of each security within your portfolio earned a different return, resulting in a weighting change. Portfolio rebalancing allows individuals to keep their risk level in check and minimise risk.

Asset Mix Proportion

The asset mix originally created by an investor inevitably changes as a result of differing returns among various securities and asset classes. As a result, the percentage that you have allocated to different asset classes will change. This change may increase or decrease the risk of your portfolio.

Let us compare a rebalanced portfolio to one in which changes were ignored and then we look at the potential consequences of neglected allocations in a portfolio. For example, George has Sh1 million to invest.

He decides to invest 50 per cent in a fixed income fund, 10 per cent in a balanced fund and 40 per cent in an equity fund. At the end of the year, George finds that the equity portion of his portfolio dramatically outperformed the fixed income and balanced fund.

This has caused a change in his allocation of assets, increasing the percentage that he has in the equity fund while decreasing the amount invested in the balanced and fixed income funds.

How to do it

The optimal frequency of portfolio rebalancing depends on your transaction costs, personal preferences and tax considerations, including what type of account you are selling from. Usually about once a year is sufficient.

However, if some assets in your portfolio have not experienced a large appreciation within the year, longer periods may also be appropriate. Additionally, changes in an investor's lifestyle may warrant a change to his or her asset allocation strategy.

Whatever your preference, the following guideline provides the basic steps for rebalancing your portfolio.

(a) Record - If you have recently decided on an asset allocation strategy perfect for you and purchased the appropriate securities in each asset class, keep a record of the total cost of each security at that time, and the total cost of your portfolio.

These numbers will provide you with historical data of your portfolio, so at a future date you can compare them to current values.

(b) Compare - On a chosen future date, review the current value of your portfolio and of each asset class. Calculate the weightings of each fund in your portfolio by dividing the current value of each asset class by the total current portfolio value.

Compare this figure to the original weightings. Are there any significant changes?

If not, and if you have no need to liquidate your portfolio in the short-term, it may be better to remain passive.

(c) Adjust - If you find that changes in your asset class weightings have distorted the portfolio's exposure to risk, take the current total value of your portfolio and multiply it by each of the (percentage) weightings originally assigned to each asset class. The figures you calculate will be the amounts that should be invested in each asset class to maintain your original asset allocation.

However, when selling assets to rebalance your portfolio, take a moment to consider the tax implications of readjusting your portfolio.

Rebalancing your portfolio will help you maintain your original asset allocation strategy and allow you to implement any changes you make to your investing style.

It also helps you stick to your investing plan regardless of what the market does.

—The writer ([email protected]) is an Investment Banker.