Should you rebalance your portfolio?

It's a good idea to spread the risk in your portfolio by investing in different asset classes. But how often should you redress the balance? Tim Bennett explains.

An old investing rule of thumb among members of the (long-deceased) Birmingham Stock Exchange recommended you keep a third of your assets in equities, a third in bonds and a third in property. That way you avoid putting too many eggs in any one basket without spreading yourself too thinly.

While you may split your own wealth into a wider range of baskets, diversification makes sense. Indeed, Tim Price of PFP Wealth Group calls diversification the "only free lunch" in investing.

But how do you stop your carefully balanced portfolio from rapidly becoming overly skewed to one asset class? Regular rebalancing is the key. Say you have split your money into five asset classes shares, bonds, commodities, cash and property, for example and want to keep a 20% weighting in each. When you next review the portfolio, prices have changed so that the bonds portion is 30%, the equity chunk 10% and the rest have stayed around 20%. You can rebalance by selling some of your bonds and reinvesting the proceeds in equities, so as to bring the allocation to each back to 20%.

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This takes the emotion out of investing. When an asset class gets frothy and leaps in value, you're forced to sell high and use the proceeds to buy low in a different area. That's sensible. As Janet Brown notes in Forbes, a 60/40 equity/bond portfolio that was rebalanced annually between 1985 and 2010 would have beaten an unbalanced one by around 9%.

There are three main challenges. The first is knowing when to rebalance. Every time you replace, say, bonds with shares, you incur dealing costs and maybe also tax on profits. However, says Jason Butler in the FT, research suggests "the risk-adjusted returns are not significantly different whether rebalancing is carried out monthly, quarterly, bi-annually or annually". So we'd suggest you do it annually.

Secondly, decide on a trigger level. As Shefali Anand notes in The Wall Street Journal, fund provider Vanguard says anything less than a 5% move will result in too frequent rebalancing for most investors. We'd favour 10%, the upper end of their spectrum. So once a 20% allocation moves more than 2% (above 22% or below 18%), consider rebalancing.

Finally, resist the temptation to overcomplicate life by having too many items in your baskets'. Passive funds such as exchange-traded funds (ETFs) offer easy ways to track attractive themes without having to juggle a portfolio heaving with individual stocks.

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.