The new year is a great time to spring clean your portfolio and get it ready for the year to come. Perhaps you want to increase your investments in a certain market, or you might be considering diversifying your assets – whatever your strategy, it’s good to assess your investment plans regularly and rebalance your portfolio accordingly.

In this blog post, we’ll discuss the importance of creating an investment plan and why it’s useful to revisit it from time to time, different types of rebalancing strategies, and tips on how and when to rebalance your portfolio.

What is rebalancing?

Rebalancing is the regular maintenance or fine-tuning of your investments. The main objective of rebalancing is to make sure that your assets continue to align with your financial plans by controlling risk exposure. Over time, your asset allocation can change due to market shifts, or your personal circumstances may change, so you’ll need to rebalance from time to time. For example, let’s say your original target allocation is 50% stocks and 50% bonds. If stock prices were to rise at a certain point and unbalance your ratio, you may decide to sell some stocks and buy bonds to restore the 50/50 split.

Why is rebalancing important?

Rebalancing your portfolio can help you stay on target with your goals, making sure that your action plan remains relevant over time. Rebalancing is also an important part of controlling risk. When putting your investment plan together, you will assess your risk versus reward ratio, and throughout the time horizon of your plan, rebalancing will help maintain that ratio. This simply means buying winning asset classes and selling those that aren’t performing in line with your strategy.

Rebalancing also means that you can compare your performance to an appropriate benchmark, giving you an accurate and meaningful idea of your progress. You could look at it as per the below chart:

Once you’ve established your risk tolerance and threshold, the above chart maps your performance against your benchmark (Zone A) and shows how portfolios can drift from their objectives. Small drifts can be expected and restored, but the further your assets deviate from the target, the further away you are from return benefits.

Pros and cons of rebalancing

Whilst rebalancing your portfolio can offer significant advantages, there are some cons to also be aware of. These include:

Types of rebalancing

There are several types of rebalancing depending on factors like frequency and tolerance range. The most common types of portfolio rebalancing are:

Calendar rebalancing

One of the basic strategies is calendar rebalancing. This simply means that investors analyse and adjust their portfolios at fixed times. This could be annual, quarterly, or monthly depending on factors like your drift and transaction cost allowance. The benefit of calendar rebalancing is that it offers a clear and regular schedule, however, the frequency you choose could cause you to miss significant market changes.

Constant-mix rebalancing

This method focuses on your tolerance threshold. Each asset class within your portfolio is given a target that reflects your risk tolerance towards that asset class (i.e 50% stocks, 50% bonds). Constant-mix rebalancing should also consider contingencies that you are comfortable with, such as a buffer of +/- 5%, depending on how markets perform.

Constant proportion portfolio insurance (CPPI)

CPPI is a trading and risk management method that allows investors to protect volatile assets during market storms. Whilst CPPI can offer security, there are no return guarantees, and the protection could be breached in the event of a sudden market drop.

Smart beta rebalancing

This is a systematic portfolio analysis that focuses on a set of values. Rather than purely assessing market exposure, smart beta rebalancing relies on several factors that are meaningful to the investor, such as the quality or size of holdings. Smart beta rebalancing could be useful for portfolios that contain a mixture of active and passive investments.

Knowing when to rebalance

There is no clear-cut answer as to how often investors should rebalance their assets. Generally speaking, it’s useful to review your portfolio at least once a year. When doing so, think about the following:

• Does your asset balance still reflect your risk tolerance?
• Are your assets diverse enough?
• How are the markets of your existing assets performing?
• Have your personal, emotional, or financial circumstances changed?

In terms of frequency, there are several ways to approach this. You could opt for calendar rebalancing and review at suitable intervals, or you might prefer a constant-mix strategy and evaluate your assets periodically. The main benefit of using tolerance thresholds as an guide is that it’s a more reactive method that could offer more control over your portfolio and risk tolerance as it’s based on real-time performance; as markets shift in or against your favour, you can rework your assets and steer them in the right direction. This, effectively, means that you buy what’s working and sell what isn’t.

You could also choose to rebalance based on your age or goals to achieve by a certain point in your life by setting yourself objectives for when you’re 25, 45, and 65, for example, and rebalance at those life stages. You could also consider the help of a wealth manager that can do the hard work for you. Portfolio rebalancing can be a time-consuming and emotional process, so a financial advisor can eliminate those tricky elements. Alternatively, a cheaper option could be a robo-advisor, a brokerage account that automates your investment process.

Rebalancing and tax

Whichever rebalancing method you choose, you may incur some tax fees, which could affect your risk threshold. The annual capital gains tax allowance per person in the UK is £12,300, so if your net capital gains surpass this limit, there are several ways to rebalance your portfolio in a tax-efficient way, such as:

Tax-free accounts

Trading through tax-free accounts such as ISAs can help avoid any unnecessary tax fees when rebalancing your portfolio and selling assets that have gone up in value.

Tax-loss harvesting

For short-term capital gains, you can avoid tax fees by offsetting your gains against your losses. For example, if you make a profit of £2,000 from a sold asset, you could offset those gains by selling another security for the same amount, totalling net zero on your tax return.

Contribute to underweight assets

A rebalancing quick fix whilst avoiding tax fees is to simply buy new assets that will help bring your portfolio back into balance. For example, if your asset allocation drifts from 50% stocks and 50% bonds to 60% stocks and 40% bonds, you could manually buy new bonds until the original balance is restored and avoid any tax or other transaction costs.

Examples of rebalancing

Some common examples of rebalancing are:

Rebelancing retirement accounts

Retirement accounts are some of the most common areas that investors look to rebalance in preparation for later life and supply retirement income. Generally, young investors tend to have a more aggressive approach whilst older investors are more conservative with their strategy. So, over the years, investors may switch to fixed-income securities like Gilts or other long-term bonds.  

Rebalancing for diversification

Diversification is an important part of portfolio management that can help protect your assets from market declines. So, if your investments are too heavily dedicated to a single market, company, or security, you may choose to rebalance them for diversification purposes so that, should you experience any losses, you’d be limiting asset exposure to that fall, thus protecting the majority of your portfolio.

Rebalancing a property portfolio

As property prices or income opportunities change, the risk tolerance of a property investor can change, too, which could mean it’s time to rebalance to maintain a suitable level of diversification. If you’re invested in property shares such as Real Estate Investment Trusts (REITs), rebalancing can be a relatively simple process. If the portfolio unbalances, a REIT investor can buy and sell REITs to rebuild the original balance. Hand-on property investors such as landlords, however, can find rebalancing more complicated.  

Invest in a balanced property portfolio

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