Automatic portfolio rebalancing allows investors to avoid emotional investing and benefit from buying low and selling high.
Common investor reactions to a falling market are to become upset, nervous and maybe even angry. It’s really important to be wary of these emotional responses to market volatility. Emotions can cause people to sell low and buy high.
It’s the job of advisors to help their clients see the advantages of volatility at every life stage, instead of simply reacting to the constant ups and downs.
Markets are unpredictable. They go up and down all the time because the values of individual companies, sectors and regions are constantly changing. Knowing that there will be volatility is the only thing we can predict with certainty: this creates a huge opportunity to put it to work for you.
One way of making volatility work in your favour is to use automatic portfolio rebalancing. Investors who work with a good financial advisor don’t need to know how to rebalance a portfolio, the advisor will do that for them.
How portfolio rebalancing works
A typical investment portfolio is made up of three parts, or asset classes:
• Equities (individual company stocks or equity mutual funds and ETFs): these investments usually fluctuate the most.
• Fixed income investments (for example, GICs and bonds): these investments typically fluctuate less than equities.
• Cash and cash equivalents (for example, money market funds): these have virtually no fluctuation, except between different currencies.
If a typical balanced portfolio has say 60 per cent equities, 35 per cent fixed income and five per cent cash, a “rebalance” would be the act of brining it back to these target allocations.
When looking at how to rebalance a portfolio that has grown in an upmarket (the equity portion of the above example now represents 70 per cent of the total value), the financial advisor would sell some equities and move the profit into the other two portions. In simple terms, they would be selling high. The opposite is also true.
If the equity portion of a portfolio falls in value, it means those investments are worth less than they were when the portfolio was last rebalanced. To restore balance, money gets moved from the fixed income and cash portions to buy equites when they are cheaper. In simple terms, they would be buying low.
This process of automatic rebalancing overcomes the emotional biases that can affect an investor’s long-term potential to generate optimal returns. When investors understand how rebalancing works, they’re less inclined to feel anxious when markets dip. They can see volatility as an opportunity to buy low and sell high.
How to rebalance a portfolio throughout your life stages
Rebalancing plays a part in helping you reach your goals throughout your lifetime. During the accumulation phase of life, you’re trying to grow your assets. In the distribution phase, you are turning your assets into an income-generating machine that will pay for your retirement lifestyle.
Discuss rebalancing with your professional financial planner
Your CFP professional can go through how to rebalance your portfolio with you and show you how it can work for you at any stage of your financial journey. They can even use technology to make this rebalancing automatic at set intervals.
A CFP colleague recently mentioned the following, which perfectly highlights why proper rebalancing is so important: “I’ve never met someone that panicked during a market downturn and sold equities that didn’t wish they’d stayed calm and capitalized six months later”.
This article is written by or on behalf of an outsourced columnist and does not necessarily reflect the views of Castanet.