Rebalancing is a vital part of any portfolio’s maintenance. To understand its importance, it is necessary to appreciate the relationship between rebalancing and diversification. Diversifying a portfolio exposes it to a variety of asset classes and their differing levels of risk. Holding many asset classes with uncorrelated returns can cancel out the volatility of any individual asset being held, reducing the overall volatility of the portfolio. When strategized properly, diversification can maximize returns while minimizing risk.
A simple example of diversification is a portfolio holding both stocks and bonds. Bonds, while typically growing at a lesser rate than stocks, are an important tool in lowering volatility within a portfolio. However, the differing returns between stocks and bonds can lead to stocks completely taking over a portfolio if left unchecked for enough time. The chart below shows an extreme example of a portfolio holding equal amounts in Large-Cap Stocks and Long-term Government Bonds starting in 1926. If this hypothetical portfolio was left alone until 2020, it would end up with 98% of its value in stocks and be unprotected from the volatility that stocks bring to a portfolio. Had the portfolio been consistently rebalanced, it would still be holding its 50/50 allocation 94 years later.
The benefits that come with diversification only persist if the portfolio is regularly rebalanced. By rebalancing on either a time or percentage-based schedule, you can maintain the benefits of diversification throughout the lifetime of your portfolio. For more information on how we can help you invest to achieve your financial goals, visit our website www.kdminvest.com.