When you first created your financial portfolio, you took several things into account, including your goals, age, and risk tolerance. You then created an asset mix you were comfortable with, which probably included a ratio of stocks to bonds. Now that you've established that ratio and your investments, it's important to continuously monitor your financial situation. As circ*mstances change over time, you may need to adjust your portfolio. In this article, we'll talk about how to keep your asset allocation on track by rebalancing when necessary.
What is rebalancing and why is it important?
Rebalancing refers to making adjustments to your portfolio when your preferred asset allocation has shifted and is an important tool to keep you from straying too far from that asset mix. There are many reasons to make changes to your original investment plan. If something has changed with your overall goals or with your life circ*mstances, you should check your asset mix and see if it still works for you.
For example, your investment time horizon is always getting shorter. An asset mix that worked for a goal originally 20 years away might not be appropriate when your goal is now only 5 years away.
The amount you want to save may change, too, if you decide you need less or more than expected.
You might also discover that your risk tolerance isn't what you thought it was. If you see your balance drop when you have plenty of time to reach your goal, you may not worry as much since you have a chance for it to recover. But if you see market volatility closer to retirement, it can be unsettling.
In addition to changes in your circ*mstances, market fluctuations may cause your asset allocation to move outside your comfort zone. Your portfolio's risk level may change even if you don't make any modifications to your investments. As the underlying value of your funds fluctuates, your allocation may begin to drift away from your target mix. As a result, you may find that you're over- or underweighted in stocks, exposing you to more or less risk than you're comfortable with.
Let's say you have a portfolio of 70% stocks and 30% bonds, and you've decided to rebalance when your allocation is off target by 5 percentage points or more. During your periodic review, you notice your portfolio has drifted to 76% stocks and 24% bonds. It's now time to make some adjustments to stay on track with your risk and return objectives. You can either rebalance your portfolio back to the 70/30 mix or set a new target if your goals or circ*mstances have changed and caused you to become more or less tolerant of risk.
