It’s a common misperception that the greatest determinant of portfolio return variability is your stock selection.
Understandably, choosing which ETFs, individual shares, active funds or other securities to invest in is often the most exciting part of portfolio construction for new investors, and of course it remains an important factor.
But as Vanguard research shows, it’s your underlying asset allocation that most explains the fluctuations in your portfolio, and not which securities you’ve invested in nor when you did.
Because of this, your strategic asset allocation is your best weapon against market volatility and the best mitigator of market risk. Sticking to it by periodically rebalancing your portfolio is likely to give you the best chance of investment success.
But wait, what is rebalancing?
Rebalancing a portfolio simply means adjusting your investments to match the target asset allocation you first decided on.
The aim of rebalancing is not to maximise your portfolio returns, but to control how much risk you’re taking on. This is determined by how much of your portfolio you put towards each asset class (as each asset class entails different levels of risk).
Over time, your portfolio will begin to drift from your target asset allocation depending on how the market has performed. For example, a boom in equities is likely to mean the value of your shares has grown disproportionately to your other assets. Because a greater portion of your portfolio is now made up of shares, the level of risk you’re now taking on has also inadvertently increased.
Why is rebalancing sometimes overlooked by new or younger investors?
While the process of rebalancing can be quite simple, the actual decision to rebalance can sometimes be met with a mental block, particularly for those who started investing post COVID outbreak and haven’t yet experienced a significant market correction. After all, selling a well-performing asset and buying an investment with lower returns seems a little counterintuitive. If shares are doing so well, why would you want to sell?
The answer lies again in risk control. A bull run in equities cannot last forever (and we’ve already started to see share prices begin to taper off). If your portfolio is overweight in equities and inadequately diversified across different asset classes, it’s likely a sudden fall in shares will negatively impact your portfolio value more than usual.
Similarly, in bear markets, investors are thought to be more risk averse. This can lead to being underweight in equities or higher-risk assets for fear of further loss, and an unwillingness to rebalance into these asset classes even though your risk level has reduced to below what’s needed to generate sufficient returns. This may be particularly true for new or younger investors who might not have a lot of capital to invest and are therefore more protective of where they allocate funds.
Why should younger investors practice rebalancing?
Rebalancing instills discipline, which is perhaps the most important trait for all investors to have. The willpower to stick to an investment plan and strategic asset allocation no matter the market climate is the most effective way to achieve your financial goals.
By practicing rebalancing early on, younger investors can refine sound investment behaviours that will remain imperative throughout their entire investment journey.
How and when should investors rebalance their portfolios?
Most rebalancing strategies are either based on a time trigger, a threshold trigger or a combination of both.
With a time-based strategy, the portfolio is rebalanced on a predetermined schedule such as quarterly, semi-annually or annually (but not daily or weekly).
With a threshold-based strategy, the portfolio is rebalanced only when its asset allocation has drifted from the target by a predetermined percentage, such as 5 or 10 per cent.
Investors can also rebalance by:
1. Reinvesting dividends. Direct dividends and/or capital gains distributions from the asset class that exceeds its target into an asset class that is underweight.
2. Making additional contributions. Add funds to the asset class that falls below its target percentage.
3. Transferring funds between asset classes. Shift money out of the asset class that exceeds its target into the other investments.
For more information on how to rebalance your portfolio, see here. Alternatively, you can contact us on 02 9554 3566 to discuss in more detail.
Source: Vanguard February 2022
Reproduced with permission of Vanguard Investments Australia Ltd
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