Credit Suisse
March 20, 2023
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Beginner's Guide to Fundamental Analysis
Make a smug face to the market — Invest with confidence using Fundamental Analysis!
As an investor, you know that diversifying your portfolio is crucial for long-term success. But did you know that rebalancing your portfolio is just as important? Portfolio rebalancing is the process of realigning your portfolio back to its original asset allocation after market movements have caused the weightings to shift. In this article, we’ll explore the benefits of portfolio rebalancing, the different methods you can use, and some tips to help you get started.
If you don’t already know how to diversify your portfolio, it’s never too late to start:
What is Portfolio Rebalancing?
Rebalancing is an act where you adjust the allocation of each asset in your portfolio based on its performance and weightage to make sure that your portfolio matches your plan for risk and performance. The usual concerns that bring rebalancing are risk and reward. (Most rebalancing exercises are done for risk concerns).
For example, if your initial plan is to diversify your portfolio according to the riskiness, for example, 40% risky, 40% medium-risk, and 20% low-risk, the riskiness of your assets may change as the economic landscape changes. To make sure that your portfolio is still in line with your initial plan, you’ll have to rebalance it again.
How to rebalance my portfolio?
Generally, there are two ways, either by selling your portfolio that rises in price and using the gains to buy a new asset — or by buying more assets to make sure that the performing asset’s weight is ‘watered down’ to its original percentage of your portfolio value.
To put it simply, either you sell the asset that is gaining weight or add more weight into other assets so that they grow proportionate to the one that is gaining weight.
The first thing is to make sure that you adjust what you need to do to your portfolio. For example, if your concern is on the level of risk — say, you have assets A, B, and C in your portfolio.
Asset A: Risky 50%
Asset B: Moderate 30%
Asset C: Less Risky 20%
Asset B suddenly become riskier, and now you have 80% risky assets in your portfolio, you don’t want to have such a risky portfolio, so what you need to do now is to rebalance your portfolio either by selling some of the risky assets and buying less risky ones, or purchase more assets to have the percentage rebalanced again (if you have the money to do so).
In the same way, you can also rebalance your portfolio by looking at how well the asset is paying you. In the same way as above, you can either sell the assets that are messing with the balance in your portfolio or buy assets that can rebalance it.
Here are the steps for rebalancing your portfolio:
- Keep track of your portfolio allocation, put it in your notes, or carve it on a rock, that’s up to you. But you need a reference point for you to rebalance your portfolio.
- The next thing that you should do is choose a certain period when you’d take a look at your portfolio again to see if the risk/reward percentage and weightage are still well-balanced.
- If you see that the balance in your portfolio is disturbed, then it’s time for a rebalance!
Rebalancing is a good practice as many investors (especially new ones) tend to hold on to assets that are performing well, hoping that the run would last. In many cases, they tend to be consumed by emotions and hold for too long, and at a point whatever gain it is that they made is no longer there.
How often should I rebalance my portfolio?
That will have to depend on a few factors such as:
- Your investment goals.
- Your needs.
- The assets that make up your portfolio.
- Your strategy.
- Your risk tolerance.
Generally, just make sure that it’s not too often nor too rare.
Types of portfolio rebalancing:
There are many ways you can do your rebalancing –
- Time — balancing portfolios at specific intervals based on status revealed through regular monitoring.
- Threshold — reallocating asset classes to have a mixed or diverse portfolio to reap maximum profits and control risk.
- Risk — rebalancing portfolios if investors realize that risks would increase, choosing to diversify investments to tackle losses wisely.
- Constant-mix rebalancing — focusing on the allowable percentage composition of an asset in a portfolio, with bands or corridors, and rebalancing when the weight of anyone holding moves outside of its allowable band.
- Constant Proportion Portfolio Insurance (CPPI) — allowing investors to set a floor on the dollar value of their portfolio and structure the asset allocation on it, with the percentage allocated to each asset class depending on a cushion value and a multiplier coefficient.
- Smart beta — periodic rebalancing similar to the regular rebalancing that indexes undergo to adjust to changes in stock value and market capitalization, using a rules-based approach to allocate holdings across a selection of stocks based on additional criteria like value or return on capital, adding a layer of systematic analysis to the investment.
Cost and Tax
One thing that you should keep your mind is that when you rebalance your portfolio, you will have to buy and sell your assets, which means that you will have to pay fees and commissions for every transaction you make. Be sure to consider how much you will have to spend on them as they may eat out your profit.
Tax-wise, if the assets being sold have increased in value since they were purchased, the investor may realize capital gains, which are taxable. On the other hand, if the assets being sold have decreased in value, the investor may realize capital losses, which can be used to offset capital gains for tax purposes.
In addition, rebalancing can also trigger taxes on dividends and interest earned from the assets being sold and bought. Therefore, it’s important to consider the tax implications of portfolio rebalancing and consult with a tax professional before making any decisions. One strategy to minimize the tax impact of rebalancing is to do it within tax-advantaged accounts such as a 401(k) or IRA.
Pros and Cons
Pros
- Managing risk and returns.
- Keeping your strategy on track.
- Weeding out emotions from investment decisions.
Cons
- May sell assets prior to its peak.
- Requires research and time.
- Portfolio can be riskier than before if asset rebalancing is wrong.
- Transaction fees.
Bottom line
- Portfolio rebalancing is crucial for long-term success in investing.
- Rebalancing helps investors maximize returns and minimize risk by realigning their portfolio back to its original asset allocation after market movements have caused the weightings to shift.
- There are different methods of portfolio rebalancing, including time-based, threshold-based, risk-based, constant-mix, constant proportion portfolio insurance, and smart beta
- Investors should keep in mind their investment goals, needs, constituents of their portfolio, strategy, and risk tolerance when deciding how often to rebalance their portfolio.
- While rebalancing may incur costs and taxes, it is a good practice to avoid holding on to assets that are performing well for too long.
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None of the material above or on our website is to be construed as a solicitation, recommendation or offer to buy or sell any security, financial product or instrument. Investors should carefully consider if the security and/or product is suitable for them in view of their entire investment portfolio. All investing involves risks, including the possible loss of money invested, and past performance does not guarantee future performance.
GameStop.
March 20, 2023
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