How rebalancing your portfolio could help you save more

When you first build your portfolio, you might not give a lot of consideration to individual weights. But portfolios change over time, some investments may do well, others may do poorly. Some investments may do well, others may do poorly. For example, a portfolio that starts out split 50/50 between stocks and bonds may easily drift to 60/40 if the stock market does well.

If this happens, most investors are thrilled – their stocks are doing well, and they hold on to them. However, as a portfolio changes, so does its risk profile – over time, a safe portfolio can become a risky one, and vice versa. You may end up with a very different portfolio than the one you planned, and be exposed to more risk or earn lower returns than you may have expected.

Buying and selling assets to restore your portfolio’s original composition is called rebalancing. Generally, this means selling some of the successful assets and reallocating your funds to other investments you still like fundamentally, but have not performed well recently. Although it might sound counterintuitive, rebalancing can potentially boost returns in a volatile market.

Let’s look at an example. Imagine two investments, Investment A and Investment B. One year, Investment A has a return of 20% and Investment B has a loss of 10%. The next year, Investment B’s returns are up 20% while Investment A loses 10%. Let’s say you have $5,000 invested in each:

year Investment A Investment A Change Investment B Investment B Change
0 $5,000 0% $5,000 0%
1 $6,000 +$1,000 (+20%) $4,500 -$500 (-10%)
2 $5,400 -$600 (-10%) $5,400 +$900 (+20%)
Total $10,800
Gain 8%

In this example, you would have earned $800 (8%) on your investments. But if you were to have taken the profits from Investment A at the end of year 1 and reallocate them to Investment B, you’d have earned $950 (9.5% - 19% more than the un-rebalanced portfolio).

year Investment A Investment A Change Investment B Investment B Change
0 $5,000 0% $5,000 0%
1 $6,000 +$1,000 (+20%) $4,500 -$500 (-10%)

Rebalance

$5,500

-$500 (-$1,000 * 50%)

$5,000

+$500 (+$1,000 * 50%)

2 $4,950 -$550 (-10%) $6,000 +$1,000 (+20%)
Total $10,950
Gain 9.5%

The rebalancing benefit is increased: by taking half of the profits ($500) from Investment A and reallocating them to Investment B at the end of Year 1, there is now more money invested in Investment B when it is down. Rebalancing helps to ensure all your eggs don’t “drift” into one oversized basket.

Of course, in this example the best case scenario would have been to invest everything in Investment A in Year 1, and then switch it all to Investment B in Year 2. Unfortunately, that level of certainty simply doesn’t exist in the real market. Since we can’t always pick winners, rebalancing is a reasonable way to hedge our investments. And, since portfolios may become less balanced over time, rebalancing helps keep them in line with your original investment plans.

If your portfolio weightings have drifted from your investment plan, it might be time to rebalance. Sign in to your Scotia iTRADE® account to evaluate your holdings. 

Don’t have an account? Open one today.