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How to rebalance your portfolio

I have previously discussed why rebalancing your portfolio [2] is a good idea. In short, by reducing or adding to your holdings in different asset classes, you can smooth your returns and keep risk within a level [10] you can tolerate.

How do you actually do it? Well, rebalancing is definitely an art more than a science.

We’ve talked before about how there are no rules for constructing the perfectly diversified portfolio [11] – unless you believe in utterly efficient markets AND you know yourself better than a Zen master and so can anticipate your reaction to any kind of market conditions!

Equally, there’s no perfect method of rebalancing. But there are definitely factors you should keep in mind.

Hence this series on how to go about rebalancing your portfolio.

Make sure you’ve read that first post [2] on why you should rebalance, and please do subscribe [12] or bookmark this site to get the rest of the series.

For the rest of this article, we’ll discuss the crucial decision you must make before rebalancing.

Remember, your own best course of action will depend on your circumstances, the trading platforms you use, whether you hold assets in pensions and so on, so do get proper advice if you need it. I’m not an advisor [13]!

1. Asset allocation is the number one aim when rebalancing

Rebalancing works when you have a firm asset allocation plan you want to stick to. For example, you might have decided the best mix of assets for you is:

Knowing that index tracking funds are the cheapest, best way [16] to get long-term exposure to equities, you could invest in each equity class via ETFs or tracker funds.

You could then use investment trusts and funds or ETFs to put the appropriate percentages into high grade corporate bonds [17] and government bonds.

Over time, different assets will deliver varying returns, moving your ideal allocations out of shape.

To rebalance your portfolio, you would trim holdings of the better performing asset classes by selling a proportion, and put the proceeds into underweight asset classes, in such a way as to set your portfolio back to your chosen allocations.

Rebalancing is automatically contrarian

Think about what this rebalancing will entail in practice. You’ll be selling an asset that is doing really well, to put money into one that is probably doing badly!

The idea is that over the long-term you’ll benefit from investing more in out-of-favor assets, as well as keeping volatility under control.

But at the time you’ll probably feel pretty queasy – you’re being asked to bet against the market and popular opinion when you rebalance.

If you don’t know your asset allocation in advance – and why you’ve chosen it – then in the face of such emotions, rebalancing is likely to become an exercise in speculation [18]. So make sure you’ve firmly decide on (and believe in) your asset mix before you start to tweak it.

Incidentally, I don’t believe you need to worry about rebalancing down to the nearest percentage point. Life is too short, and trading too costly. Keeping things roughly in balance is the aim.

Series NavigationRebalancing asset allocations [2]When should you rebalance your portfolio? [3]