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.
This publication has been prepared by Scotia Capital Inc. (“Scotia iTRADE”) and is intended as a general source of information and for educational purposes only and should not be considered as personal and/or specific financial, tax, pension, legal or investment advice. This publication does not take into account the specific personal, financial, legal or tax situation or particular needs of any specific person. No information contained in this publication constitutes a recommendation by Scotia iTRADE to buy, hold or sell any security, financial product or instrument discussed therein. The information contained in this publication neither is nor should be construed as an offer or a solicitation of an offer by Scotia iTRADE to buy or sell securities or to follow any particular investment strategy. Scotia iTRADE does not make any determination of your general investment needs and objectives, or provide advice or recommendations regarding the purchase or sale of any security, financial, legal, tax or accounting advice, or advice regarding the suitability or profitability of any particular investment or investment strategy. You will not solicit any such advice from Scotia iTRADE and in making investment decisions you will consult with and rely upon your own advisors regarding the appropriateness of implementing strategies before taking any action based upon the information contained in this publication. Opinions and projections contained in this publication are our own as of the date hereof and are subject to change without notice. While care and attention has been taken to ensure the accuracy and reliability of the material in this publication, neither Scotia iTRADE nor any of its affiliates make any representations or warranties, express or implied, as to the accuracy or completeness of such material and disclaim any liability resulting from any direct or consequential loss arising from any use of this publication or the information contained herein. This publication and all the information, opinions and conclusions contained herein are protected by copyright. This publication may not be reproduced in whole or in part without the prior express consent of Scotia iTRADE