How Often Should I Rebalance My Portfolio to Diversify My Investments?
Investors sometimes make the mistake of forgetting to rebalance their investment portfolio. However, professional investors resist the temptation to “set it and forget it.” They understand that risk tolerance and asset allocations change with time.
Regular rebalancing of a diversified investment portfolio is different from “day trading” or “short-term investing.” As the market fluctuates, the value of your holdings will go up and down. This will knock your ratio of low-risk to higher-risk investments out of whack.
If you’re concerned about maintaining the sophisticated balance of your diversified investment accounts, you’re in the right place. In this article we’ll answer the following questions:
- What does a diversified portfolio look like?
- How often should investors reallocate a diversified investment portfolio?
- What are the strategies you should consider when rebalancing your portfolio?
- What are the common mistakes that savvy investors avoid when reallocating their portfolio?
What does it mean to have a diversified portfolio?
Think about where you are in life. Are you younger, with many years of potential earnings ahead of you? Are you approaching your target retirement age? Maybe you’re somewhere in between.
A diversified portfolio helps you manage risk. Your risk tolerance changes based on where you are in life.
A qualified retirement advisor can help you determine your risk tolerance and craft an investment strategy to meet your needs. Generally, they will use a mix of stocks (higher-risk) and bonds (lower-risk).
Stocks can be more volatile and may carry more risk, but they have a higher earning potential. Bonds are usually considered safer investments because they provide a predictable, guaranteed return over time. But their rate of return is usually lower than a diversified collection portfolio of stocks over a long period of time.
Bonds can offer a hedge against the volatility of stocks, especially during times when the market is underperforming.
The number of stocks you choose to invest in can also help you create a diversified portfolio. Most investors avoid purchasing all of their stocks in the same sector. This helps to hedge against poor volatility in any one market sector.
It’s also important to pay attention to the underlying financial performance of the companies you’re holding in your account if you aren’t invest in professionally managed funds. Investors with a higher risk tolerance may choose to invest in high-growth funds. They are more volatile, but they can offer higher returns since these companies are still in their growth phase.
Investors with a lower risk tolerance may choose to hold stock in more established, stable companies. They are typically referred to as value stocks and while the growth potential may not be the same, these stocks typically pay higher dividends than growth stocks. Just keep in mind that past performance is not a guarantee of future results.
How often should I reallocate to maintain a diversified investment account?
Generally speaking, stocks will outperform bonds over time. This can mean that the ratio of stocks to bonds in your account will change.
If the value of your stocks increase, they will naturally begin to represent a larger percentage of your portfolio. You will need to regularly reallocate the funds in your investment account in order to maintain your preferred blend of higher-risk to lower-risk investments.
Unsystematic Risk. These types of risks are specific to certain segments of the market. This could include poor management behavior, natural disasters in certain geographic areas or an industry-wide strike by a union.
It’s the job of every savvy investor to consider and learn about the threats that could impact their investment portfolio. As risk-profiles change, investors need to update their investment model to reduce risk through diversification.
Diversification is a powerful tool because it allows you to counter-balance risk across your portfolio. For example, if you’re invested in both aviation and railway stocks, an aviation mechanic strike would have a lower impact on the value of your investments. Some of the under-served airline transportation contracts may be transported by railway traffic. The spike in railway stocks can off-set your loss in the aviation sector. This is just one example.
Each investor has a unique blend of stocks, bonds and other securities in their retirement account portfolio. Your best bet is to consult a trained investment professional. The advice outlined here is simply meant as a guide to help you understand how diversification can help you reduce risk, as long as you maintain a sensible ratio of higher-risk to lower-risk investments.
Strategies for Diversifying Your Retirement Portfolio
There are two popular strategies that investment professionals use to maintain diversification of their investment funds: Periodic Rebalancing and Risk Tolerance Based Rebalancing.
Periodic rebalancing involves reallocating the funds in a retirement account at regular intervals of time: monthly, quarterly or annually. Most investors should reallocate their investments at least once a year to maintain a comfortable level of risk.
The problem with periodic rebalancing is that some studies indicate it does little to reduce risk and results in higher transactional costs (trading fees, disbursement costs, etc.).
If you can constantly monitor the risk threshold of your investment account, it may make more sense to use risk tolerance-based rebalancing. This means that you’ll only rebalance your investments when the level of risk reaches a specific threshold.
This eliminates unnecessary transaction costs but can be dangerous if an investor or investment professional fails to carefully monitor risk.
Mistakes to Avoid When Reallocating to Maintain Fund Diversity
- Fintech apps that offer automated investing and portfolio management are becoming increasingly popular. But it’s hard to beat the subjective wisdom of a human fund manager. Don’t rely on algorithms alone to manage your account.
- Understand the types of investment vehicles are you are selecting when reallocating. Are the funds active or passive? Fees can vary significantly and have a big impact on portfolio returns.
- Don’t forget to calculate the tax implications of your reallocation. Unexpected capital gains taxes during tax return season are never fun.
Remember, your best move is to consult a qualified investment professional to discuss your specific needs.
Danny G. Michael is the founder and CEO of Satori Wealth Mangement, Inc. He has 20 years of experience in retirement planning working with individuals, families, and business owners.