Diversifying your portfolio with a mix of assets, like stocks and bonds, is a good way to lower risk and smooth out returns, but it’s not something you can just ‘set and forget.’
Over time, your asset mix will shift as your holdings gain or lose value. Re-balancing your portfolio from time to time – either by yourself or with your financial advisor – is part of the regular maintenance you need to do to keep your asset mix close to your financial plan and on track with your goals.
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Re-balancing your asset mix
A diversified portfolio will hold a mix of different assets like stocks and bonds. You can diversify these holdings even further by investing across various sectors and seeking opportunities outside of Canada. When you set up your portfolio, these different asset classes make up a predetermined portion of your holdings. The asset mix that makes sense for you will depend on your objectives, time horizon and risk tolerance.
The investment mix within your portfolio will change as the value of your holdings go up and down with the markets. As this happens, the holdings that are doing well will account for a larger share of your portfolio. While this may sound positive, it may not support your goals over the long term because it could increase the risk of your portfolio. Re-balancing will help to bring your risk back in line.
For example, let’s say you start with a portfolio that was 60% equities and 40% bonds. If equities increase in value and bonds remain relatively unchanged, the asset mix in your portfolio could be closer to 70% equities and 30% bonds at the end of the year. If unchanged, one asset – or possibly a single company or fund – could have an outsized impact on your performance. Re-balancing will also help lower volatility and smooth out your returns.
Restoring your portfolio weightings to your original plan will allow you to maintain the benefits of diversification.
How to re-balance
There are two common ways to re-balance your portfolio. If you regularly add funds to your portfolio, you can use that as an opportunity to restore your asset mix to your original ratio.
For instance, if the bond portion of your portfolio falls behind your plan, you would direct those new funds to that part of your portfolio to restore the balance. If you are contributing new money to your portfolio and the asset mix is already balanced, you’d simply distribute those funds according to your plan.
If you are not able to invest money to re-balance your portfolio, you can restore your asset mix by selling some investments and redistributing those funds. With this approach, you would sell your investments from the asset class that has a higher weight in the portfolio and re-direct those funds to the other assets in your portfolio until you restore the balance.
While some investors may find it hard to sell their best-performing investments, this discipline will help you lock-in gains on your best-performing investments. It will also ensure you’re directing those funds to assets that may be undervalued, lowering the risk that you’re going to overpay. If you decide to sell, always take into account the fees associated with the transaction as well.
Re-balancing frequency
While your asset mix will always be in a state of flux, you don’t have to react every time your portfolio drifts from your plan. Re-balancing frequently can also increase costs associated with buying and selling investments.
For many investors, re-balancing once or twice a year should be sufficient. Try to re-balance at the same time each year; this has the added benefit of helping you control emotions that can influence your decisions.
Diversification is an effective way to lower your investment risk, but it is only effective if you actively re-balance your portfolio.
Take action
- Pick a memorable date like a birthday to remind yourself to re-balance your portfolio
- If you are adding money to your portfolio, try using those funds to re-balance first
When re-balancing, selling investments that have climbed the most will help you lock-in your gains and reduce the overall risk of your portfolio
