You’ve no doubt often seen and heard the term “rebalancing” when it comes to portfolio management, but what does it really mean when one strips away the jargon, and why is it so important?

Rebalancing is “the action of bringing a portfolio of investments that has deviated away from one’s target asset allocation back into line” (wikipedia). Because investments in a portfolio perform according to the market, over time certain investments may grow while others may decline. To bring the portfolio back in line with the original asset allocation, under-weighted investments can be purchased with newly saved money; alternatively, over-weighted investments can be sold to purchase under-weighted investments.

For example, assume your asset allocation comprises 60% equity and 40% bonds (your asset allocation should in turn be based on your investment goals). Over a period, your stocks perform spectacularly well and the growth results in stocks rising to 80% of your portfolio’s value. In this instance, the portfolio has potentially become too risky for your investment objectives and needs to be re-aligned or rebalanced.

For years, investors have heard the mantra of investing for the long term.  That is, to create a portfolio based on your goals and stick with it despite the rumblings of a fickle market or the allure of popular trends. In theory, this is a suitable strategy for some investors, but staying the course wisely should also acknowledge the need for the occasional check-up and oil change when required. Simply stated, staying the course doesn’t mean driving with blinders.  Investors should monitor their portfolios regularly to determine if they still support their financial goals.

How often should you rebalance?

Should you rebalance quarterly, semi-annually or annually? Or should you wait until your various asset classes shift a certain amount away from their targets? There is no right answer to this question, and there are proponents for all of these options. The truth is that no matter how often you choose to rebalance, any rebalancing is generally better than no rebalancing at all. The prevailing view, however, seems to be that rebalancing annually appears to work well for most general investors without incurring too many trading costs. The following are also important points to remember when rebalancing your portfolio:
- set dates for rebalancing and stick to them;
- don’t be swayed by your emotions and stick to your rebalance dates;
- don’t try time the market.

What is the best way to rebalance?

The general rule of thumb is that if you’re in a taxable account, selling overweight investments will trigger tax consequences (in the form of capital gains or losses). So it’s best to add (or increase) new contributions to the under-weighted allocations and avoid incurring taxes. For tax-deferred accounts, just shift (transfer) assets to restore you target allocation since no taxes would apply.

Steps to better portfolio management

Making sure you rebalance your portfolio is key. Here are some other aspects you should be thinking about:

- Construct an initial portfolio with a goal-sensitive allocation of stocks, bonds and cash. There are several online tools to help you with this exercise in addition to your broker (Jemstep will be introducing its asset allocation tool in the near future).

- Be aware of your short- and long-term goals when designing your portfolio.

- Generally, make more comprehensive rebalancing an annual event. Many experts agree that investors who rebalance at this interval or slightly longer reap many of the same benefits as those who do so more often.

- Remember that rebalancing comes from paring down or eliminating specific investments in a portfolio. In many cases there may be tax consequences, like realized capital gains. Try not to burden yourself with tax liabilities you may not be prepared to handle. Yet at the same time, you must weigh the benefits of overall return over some tax savings.

- Consider contributing to your portfolios via a systematic or dollar-cost averaging strategy. Systematic investing, the process of making consistent contributions on a regular basis, can help bring you closer to your financial goals.

- Stand by your plan. Your portfolio was created to respond to a number of scenarios and goals. Don’t allow yourself to be easily swayed by the latest trends.

Effective portfolio management  need not be as daunting as it seems if you keep these few time-tested pointers in mind.