Portfolio rebalancing

Can you explain rebalancing to me?

Let’s say a legacy from a maiden aunt 👵🏼 leaves you with an extra £1,000 available to invest. You decide to put 90% of it in stocks and 10% in bitcoin – the massive risks mean you don’t want to bet all the money on cryptocurrencies, but you think it’s worth a punt. It’s what Glenda would have wanted. 🙏

Turns out you (and Glenda) were right: your £100 of bitcoin immediately shoots up in value to £1,100! Cryptocurrencies are known for their wild price swings, whether that is up or down. Combined with the £900 worth of stocks, your portfolio is now worth £2,000: a delicious 100% return.

But your portfolio is now predominantly made up of bitcoin. A very volatile asset. Have a think: if Glenda had given you £2,000, would she really have approved of you putting 55% of it in bitcoin? Probably not – that’s pretty risky, even for a woman who did a bungee jump at 75.

Your initial plan was to put only 10% of the cash in bitcoin: just because your gamble’s gone well doesn’t mean that it’s any less of a gamble or that you should be taking on more risk than you’d wanted. 😷

To bring your risk back down to your target level, you now need to rebalance. That means selling most of your bitcoin, leaving you with £200 worth – and using the proceeds from the sale to buy another £900 of stocks. You’re back to a 90/10 stock/crypto split, and your portfolio reflects the risk you’re actually comfortable with.

We should mention that the returns above are just numbers we’ve used to illustrate how portfolio rebalancing works.

Doesn’t this mean selling the investments that are doing the best?

It does indeed. But that’s because you’re not gambling on individual assets – you’re trusting your asset allocation. It’s slightly counterintuitive, but by taking action to buy and sell, you’re explicitly not taking a view on the success of any one investment. Rebalancing lets you take the emotion 🥰 out of investing and, in doing so, helps you better manage your risk.

Rebalancing can also be good for your returns, too. If over the long run, your different investments’ gains average out – so bitcoin falls and stocks rise – then by cashing out your crypto once you’ve made a profit and putting that money in stocks, your portfolio should see better returns than if you’d just left your investments untouched.

The theory here is that, like a pro surfer, you can keep on riding the good waves – without staying in any single tunnel long enough to wipe out. 🏄

How often should I rebalance?

It depends. Analysis from East West Investment Management shows that rebalancing on a quarterly basis might be best. Its dummy portfolio of Canadian 🇨🇦 stocks and bonds, split 60/40, performed best when it was rebalanced every three months – but the company found that any rebalancing is better than none at all.

If you manage your own portfolio, you’ll have to rebalance manually, buying and selling assets to keep everything at your target level. If you’re using Wealthyhood, though, you don’t have to worry about this – you can rebalance your portfolio anytime, with the tap of a button! 😎 Or even set up automated rebalancing!

In the next chapter, we’ll investigate why some people advocate not rebalancing at all.

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Remember - when you invest your capital is at risk. This learning guide is for information purposes. Past performance is not a guarantee of future returns. Although this material is intended to be educational, it may promote the services provided by Wealthyhood.