Why now is a good time to rebalance your portfolio

Rebalancing your portfolio is a healthy financial habit. But it could be particularly important this year, says John Stepek.

When it comes to New Year’s resolutions, setting goals is old-fashioned. These days, say the productivity gurus, it’s all about developing good habits. One healthy financial habit to acquire, if you haven’t already, is the practice of rebalancing your portfolio at least once a year. Rebalancing is a simple concept. When you invest for the long term, you should have a plan in mind as to where you are going to put your money. This is known as “asset allocation”. It doesn’t have to be complicated – we generally suggest a division between stocks, bonds, property, gold and cash. Your precise asset allocation will depend on your time horizon and risk appetite (which in turn should mostly depend on your time horizon).

Of course, as time goes by, the percentage split of your portfolio will diverge from your initial asset allocation. If your equity holdings rise faster than your bonds, say, then you’ll end up with a bigger chunk of your money in stocks than you had originally planned, which theoretically means your portfolio has become riskier. The point of rebalancing is to bring it back into line when it has diverged sufficiently from your original plan.

Rebalancing won’t always result in a better performance than leaving your portfolio alone. But most studies (and logical intuition) suggest that in the long run there is a benefit in terms of reducing the risk of big drawdowns (ie, years where your portfolio loses a lot of money) without sacrificing much, if anything, by way of returns.

The times they may be changing

Another good reason to rebalance is more specific to this year. We’ve gone through a lengthy period in which the gap between the returns on various asset classes and strategies has hit extreme levels. For example, commodities have gone through a long period of underperformance versus all other assets; value has been hammered relative to growth; and US markets have run well ahead of equity markets everywhere else. 

That may continue – we don’t have a crystal ball. But there are signs of change. At a “big-picture” level, markets are starting to anticipate the return of inflation, particularly as higher US government spending seems likely if the Democrats do indeed take control of the Senate. This would imply a very different backdrop to the one we’ve seen over the past decade or so. If inflation returns, it implies that the assets which did best in the disinflationary post-financial crisis world – such as big tech stocks – will start to lag, while the sectors and assets that have struggled since then (including banks and gold) will benefit. So if you review your portfolio now and find that you are heavily exposed to the former, it might be a good time to take some profits and invest in the latter.

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