Before you started investing, you established your investor profile to determine the optimal asset allocation that would help you achieve your financial goals. Your portfolio's target asset allocation is the backbone of your investment discipline, because it is what you refer to before making any adjustments to your portfolio in response to market fluctuations.
Over time, investments in a portfolio may start generating different returns, which could cause your original asset allocation to shift such that it may no longer match your objectives. In order to stick to your plan, you may need to take the time to rebalance your portfolio.
This means moving funds from one asset class to another (cash, stocks and bonds) to ensure you stay on course with your initial allocation. For example, having a weighting in stocks greater than your initial allocation could increase your portfolio's performance, but it also exposes a greater portion of it to a potential stock market correction.
When rebalancing your portfolio, you may consider selling certain assets that have gone up in value and destabilized your asset allocation to buy securities from underweight classes and get back to your original asset allocation.
It may not seem logical to sell securities that are performing well to buy securities from an underperforming class, but by remaining disciplined and sticking to your plan, you can take advantage of market bargains and optimize your portfolio's performance based on your longer-term goals. In other words: buy low, sell high.
Diversification is a key contributor to your portfolio's performance. Rebalancing aims to re-establish the desired asset mix, while maintaining optimal diversification. This may involve some emotion, and putting in practice a rebalancing strategy is key. It may be performed at a pre-determined frequency (every six months, once a year), at a predefined threshold when the allocation is straying too far away from the target (5 or 10%, for example), or using a combination of these two methods; in other words, periodically monitoring the portfolio and rebalancing it when it starts to shift too far from the target.
Rebalancing also provides an opportunity to review your strategy. There may be changes in your personal situation or goals that justify increasing or reducing your weighting in equities, bonds or other asset classes to properly reflect your new risk tolerance.
It's an exercise all investors must practice!
3 questions to ask yourself
- Is my portfolio still on course with the asset allocation I initially established?
- Given market performance and volatility, is my target asset allocation still consistent with my investor profile?
- Some of my investment objectives have changed. Should I review my target allocation?