Developing and sticking with a long term investment plan is an important strategy for investors to achieve their goals. But when it comes to asset markets, nothing stays the same for long and one of the keys to successful investing is to regularly rebalance your portfolio.
If you have constructed a diversified portfolio of assets give yourself a pat on the back. Diversification is a useful tool to cushion your wealth against dramatic falls in any one investment market. However diversification shouldn’t be an ad hoc process. It is critical to make deliberate decisions about how your investments are spread across various asset classes – the technical term for this is ‘asset allocation’.
You may start out for instance deciding that you would like Australian shares to make up say, 30% of your total portfolio with the balance spread across other asset classes. Over time though, your portfolio weightings will change in line with market fluctuations.
If the sharemarket races ahead for instance, you may find your portfolio starts to have quite different weightings without you having done anything to change it. The sharemarket’s surge could mean Australian shares now comprise about 40%, rather than 30%, of the value of your investment portfolio.
This is significant because the higher share weighting means your portfolio now has more risk than on Day One. This is because shares are one of the higher risk mainstream assets. Unless your attitude to risk has changed (in this case, where you are happy to take on more) it is sensible to rebalance your portfolio back to the original weightings, and this process should be done at least annually, and definitely after major life events like shifting from full time work to a part time role ahead of retirement.
The actual process of rebalancing involves two steps. First, take a look at the current values of each of your investments and crunch the numbers to determine if they mirror the original proportions, or asset allocation, you established for yourself and would like to maintain.
The next step is to bring your asset holdings back into line with your preferred weightings. You can choose to sell some investments as part of this process, and yes, this may incur switching costs – you may even be up for capital gains tax on profits.
An alternate approach is to drip-feed cash into the asset classes you are underweight in, to build them up. This can avoid triggering a capital gains tax liability on the sale of investments.
Whichever approach you take, the key issue is to get into the habit of rebalancing. If you don’t rebalance, you may be unpleasantly surprised at how much you could lose if the asset area you’ve become overweight in has a market fall.
If you are uncertain about how to rebalance your portfolio, speak with your financial adviser.