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Benefits of Rebalancing

benefits-of-rebalancing-graph

We all know about the dangers of putting all your eggs in the one basket.

An investment portfolio is like a collection of baskets, all with money (eggs) in them.

Some baskets have a few eggs while others may have more. The important thing is that the ratio of eggs in the baskets remains constant.

Designing an investment portfolio is very similar. You have a collection of different investments (baskets) and you put a different amount of money (eggs) in each.

For example, a balanced portfolio will have money invested in shares, property, fixed interest and cash.

A growth investment portfolio will have the same amount of money invested in the same types of investments but will have more money in shares and property. 

Financial markets go up and down. They go through cycles.

During one of these cycles, the share market may go up, property prices may go up and interest rates may rise - all at different rates.

During downturns, share prices will go down, property values may go down and interest rates may also go down - all at different rates.

In the case of our baskets, during good times (good economic times) someone comes along and puts some more eggs in the baskets. They may put all the extra eggs into one basket or spread their generosity evenly in every basket. The result is that we now have more eggs but our ratios are wrong.

Again in the case of our baskets, during poor times (market downturns) someone comes along and takes some of our eggs. They may take all their eggs from one basket or take a few from each. The result is that we will have fewer eggs and our ratios are wrong.

In both cases, in order to get our eggs back to our original ratios, some eggs will have to be moved from the basket they are in, to another.  

This is called rebalancing.

In order to keep your portfolio in shape you have to monitor it on a regular basis. To make sure that your assets have not become lopsided, your portfolio needs to be rebalanced.

Rebalancing has three potential benefits: it will ensure that adequate cash is always available, it will reduce variance and importantly, rebalancing has the potential to enhance your returns. 

Periodic rebalancing of a portfolio is an important method for maintaining proper diversification within a portfolio as your asset ratios change over time.

Rebalancing will return your portfolio to your predetermined asset class allocations (original ratios) and allows you to control the relative contribution of each asset class to the overall diversity of your portfolio.

Without rebalancing, the variance of the portfolio will be skewed towards the highest performing asset class and put your portfolio at risk.

This happened in the years leading up 2008 when equity markets were the fastest growing asset class. Such a neglected portfolio would have been over-weighted in shares just in time for the Global Financial Crisis. 

For some people, the Global Financial Crisis was like dropping the basket that had all their eggs in it.