Performing the great rebalancing act


How to make sure your investment portfolio stays in line with your aims

Savers who use default options, such as the default fund in their employer’s workplace  pension scheme, effectively delegate all their investment decisions to a fund manager. This is also true of individual savers and investors who invest their individual savings accounts (ISAs) and self-invested personal pensions (SIPPs) in ‘ready-made’ or ‘managed’ funds or collections (portfolios) of funds.

However, everyone – both workplace and individual savers and investors – has the ability to make their own choices. This could be from the full range of available funds, or from a more limited range selected by investment experts.

In the case of people who have chosen the default or ready made options, their chosen investment manager will decide how and when to rebalance. 

Savers and investors who prefer the do-it-yourself style should remain aware of the need to regularly rebalance their portfolio of chosen funds. This ensures it remains within their risk appetite and in line with their investment objectives.

What does rebalancing involve, and why could it be a good idea?

Rebalancing simply means changing your portfolio of investments to bring it back into line with your current investment aims. Investment portfolios tend to get out of kilter if one particular asset, for example shares (equities), grows faster or slower than other parts of the portfolio.

This is particularly true when there is a ‘stock market correction’– what the media loves to call a market crash. I’ll use a simple example to illustrate this:

Rebalancing in action

Let’s say that I have £100 in my portfolio. In line with my personal risk tolerance, and to meet my financial objectives, I have invested as follows:

•  £50 (50%) in shares
•  £30 (30%) in (government and company)  bonds
•  £20 in cash

The stock market then falls by 20%. This leads to an increase of 10% in the price of bonds, since investors see them as a safe haven. My investment portfolio now looks like this:

•  £40 (43%) in shares
•  £33 (35.5%) in bonds
•  £20 (21.5%) in cash

In total, my portfolio is now worth £93, a fall of 7% from its starting point. However, the percentage of my portfolio in each asset is now out of line with my original objective of 50%, 30% and 20%. To reflect this, I now need to change the portfolio as follows:

•  £46.50 (50%) in shares 
•  £27.90 (30%) in bonds
•  £18.60 (20%) in cash

Rebalancing an investment portfolio in this way may feel counter-intuitive. After all, the stock market has just fallen by 20% and the rebalancing requires me to buy another £6.50 of shares and sell £5.10 of bonds (which have just gone up by 10%) and £1.40 of cash.

Although it might feel uncomfortable, this action is completely in tune with the first maxim of investment ‘buy at the bottom, sell at the top’. Granted, we don’t know if we have reached the bottom yet – but we do know that shares are 20% cheaper than they were before the stock market fell.

It can be a good idea to do this every 6-12 months under normal circumstances and immediately after periods where the market has gone through a period of instability. Maintaining this discipline of rebalancing your investments regularly will mean that you are always selling assets which have gone up in value and buying assets which have become cheaper.

Regularly rebalancing your portfolio also means that you will not be taking more risk than you are comfortable with, or more than you need to, in order to meet your income or growth objectives.

Does rebalancing always work?

Whilst rebalancing is a good discipline, forcing you to sell assets that have gone up in value and buy assets that haven’t done so well, there are a couple of circumstances where it may not work in your favour.

1)  If an asset goes up in value over a sustained period, as equities did during the 1980s and 1990s, selling out early means that you don’t benefit from future growth.

2)  If there is a sustained downturn over a long number of years. In this case, rebalancing means you end up buying more of the same asset that keeps going down in value and you may have to wait a long time to get your reward. 

This means rebalancing works best when asset values are volatile over shorter periods of time. 

John Lawson

Head of Financial Research


AR01476  09/2015

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