Investors are a lot like tightrope walkers. If the high risks pay off, then there is a lot there to admire and the reaction is an impressive one. However, if the executor is poorly trained, the injuries can be very damaging. The key skill for these two daredevils to master and finesse is balance. In this article, I will discuss how and when to rebalance your investment portfolio.
But before that, let's understand the various terms, investment portfolios and avenues.
Why Balance Your Investment Portfolio?
Experienced and skilled Forex Market investors know that you cannot just set a portfolio and then leave it at that, never minding the changes that happen in the financial markets’ landscape.
Even if you’re the wolf of Wall Street, you still have to review and rebalance your portfolio every now and then. In other words, even highly successful professionals reserve a time for rebalancing their portfolios.
Your allocation may be top-notch, but prices still oscillate and the markets move. Economic changes are inevitable. Consequently, asset prices continuously change.
It is very important, therefore, to consider how these changes affect your asset allocation model. This activity is also known as portfolio rebalancing.
What is Rebalancing?
Portfolio rebalancing is a very elemental strategy in investing. When you rebalance your portfolio, you realign the weightings of your portfolio of assets, and you always make sure that you don’t allocate too much in any one of your asset classes.
Simply put, you buy and sell portions of your portfolio in order to bring the weight of each asset back to your target allocation.
For instance, suppose your target allocation is 30 percent equity securities plus 70 percent fixed income securities. Imagine that the equity market has rallied in value across the board. While this event happens, your equity positions rise in value. Your consolidated allocation for equity securities would now make up 45 percent of your portfolio.
Even though capital appreciation is your goal, your allocation is still out of balance. Since your original target allocation is 30 percent equity and 70 percent fixed income, you must rebalance to take your allocation back to your original allocation plan.
When should you rebalance your portfolio?
There’s really not one formula or target date when it comes to rebalancing one’s portfolio. In fact, one may go further and say that it’s very conditional and circumstantial.
Bear in mind that no two investors are the same. You are a different kind of investor from your best friend even if you share very similar personalities. Therefore, portfolio rebalancing practice differ from one investor to another.
There are investors who rebalance on a fixed date or schedule. These investors typically do the job of rebalancing every quarter, two times a year, or yearly.
Meanwhile, other investors simply wait until their asset allocations have already fallen out of their target allocations.
Keep in mind, though, that having to rebalance too frequently may mean there’s something wrong with your investing strategy or the asset allocation target you are using.
Why is rebalancing your portfolio important?
Rebalancing your portfolio on a regular basis has many inherent benefits.
When you incrementally rebalance, you can capture the gains yielded by your over-performing assets. Along with that, you would be able to buy under-performing assets at a lower price, awaiting their future price appreciation and therefore waiting for more profits to come.
More importantly, rebalancing your portfolio allows you to maintain the risk level within your portfolio, effectively reducing your downside while protecting your upside.
Good Investment Portfolio vs Bad Investment Portfolio
See, there is nothing such as a bad investment.
A good investment can become bad if not handled properly.
The terms good and bad for investments are relative to the investor and his expectation for returns.
Everyone would like to earn a fortune out of their investments but it is impossible to do so without facing risk; risk of losing one's hard earned money. Investments are made to meet specific financial goals and one wrong step could take one’s plan back over years.
Modern investment theory states that, "High risk, High returns; Low risk, low returns".
This gives the possibility of high returns on high risk, not the guarantee of high returns as there are chances of high potential losses also. Hence, before investing a person needs to be certain about his risk bearing capacity and various investment options to suit his financial condition, risk tolerance, life situation and financial goals.
It is important to balance risk and return while investing to achieve a trade off. If a person’s investments are giving him too much anxiety, it cannot be termed as a balanced investment.
Risks in Investment
Risks cannot be totally cleared from investments, but the amount of risk associated with a particular investment should be acceptable. Acceptable risk means managing and controlling risk and returns so that the returns are maximized and risk minimized.
One of the basic rules of investing is to make diversified investments.
This is the best method to spread the risk across various investments instead of concentrating it in a single place.
Sometimes, losses in a particular investment are offset against the profits from other investments in a diversified portfolio. Diversification of investments means investing in different high risk as well as risk free instruments to reduce the inherent risk in a particular investment.
The proportion of investment in different risk bearing securities depends on the risk tolerance of a person.
A young earning individual can put more in risky instruments while an old age person can keep more amounts in fixed income securities.
There is no thumb rule that specifies the percentages of investments in different securities; it is relative to the person investing.
There are a variety of financial and non financial instruments to choose from for investing. On the basis of risk involved these can be classified as:
Lowest Investment Risk Instruments
In these instruments, the probability of difference between actual returns and expected returns is less. They have a fixed or guaranteed rate of return. These are usually highly liquid instruments or cash equivalents. These include:
- Bank Deposits
- Certificate of Deposits
- Commercial Papers Treasury
- Bills Government Bonds
Moderate Risk instruments
In these instruments, the probability of difference between actual returns and expected returns is medium. They have a variable rate of return. These include:
High risk instruments
In these instruments, the probability of difference between actual returns and expected returns is high. They have a variable rate of return but as the rists are high, returns are high too. These include:
- Equity - Investment in Stocks
- Art and collectibles
- Non convertible debentures.
- Real Estate
- Foreign Exchange Trading
The time horizon (time durations for investments) also needs to be considered with the financial goals before deciding on the types of investment. The performance of investments also depends upon the economic and market situations.
But these factors cannot be controlled by an investor and hence predicting risk is difficult. An investor can always be on the safer side than others and create wealth by making calculated, wise investment decisions.
Now, talking about how to rebalance your investment portfolio, I have four ideal suggests for you.
- Proper Asset Allocation
- Staying Up to date with Financial News
- Some Personal Considerations
- Also, some extra suggestions.
Whether you like to make pie charts or prefer to work numbers and percentages, it is critical that you take time to notice and analyze market trends.
Typically, let’s say you have a fifty-fifty split with your investments, in stocks and bonds. If stocks are doing better, then it’s time to raise your percentage in your equity proportions. However, allocating your assets is also about risk control.
It’s about understanding the volatile nature of the rise and fall in the stock market. Each year, you must be prepared to sell stocks to get back to a stable point so that you don’t lose out on a steady return.
Keep Watch on Financial News
The Dow Jones, Nasdaq, and NYSE etc. are crucial places to keep up to date with financial news and changes in the market. Creating a stocks to watch list and keeping up to date with what’s moving that market will help you to create the most rewarding financial profile.
There is no set formula as to how you go about selecting your stocks, but knowing what can move the market is important. It is a very subtle blend of being shrewd but decisive and active at the same time.
You have to follow supply and demand rates and plot when is the best time to invest in a specific stock. In order to organize your prospects effectively and lucratively, you really ought to have an interest in the market’s strongest players. There are several big areas to consider such as software, commodities, retail, automotive etc.
Finances and emotions combined can often lead to an unmitigated disaster. Think of a buzz wire game. The coiled metal represents the stock market and your portfolio is the hoop which loops around.
Going at it too quickly and erratically sends the hoop colliding with the metal and off the buzzer sounds. If you can’t then regain your composure you will wobble, causing a flurry of jolting bleeps. Yet, if you don’t play confidently and swiftly in some ways, you will second guess yourself causing your hand to shake and falter too.
This all means that your attempt at the game will be a rocky and stressful one. Much like your experience in trading will be if you allow your emotions to tip to one extreme or the other.
By being too cautious and slow you will grow anxious and perhaps miss out on several great opportunities.
Yet acting too hastily, in a gambler-like way, could result in you taking unnecessary risks. Iron out the kinks, create a smooth line strategy and adjust your portfolio accordingly.
Decide your comfort zone and use experience to guide you. Work out how much you have to lose, as if this is your primary or secondary income.
Think about whether you have a set time scale to work towards and let this rearrange and fix down your financial checkpoints.