Understanding Portfolio Rebalancing Impact on Performance

Portfolio rebalancing is a crucial investment strategy that involves realigning the proportions of assets in a portfolio. This process helps to maintain the desired level of risk and return by adjusting the portfolio back to its target asset allocation. The impact of rebalancing on performance can be significant, especially over the long term. In this article, we will explore three diverse examples that illustrate the effects of portfolio rebalancing on investment performance.

Example 1: The Growth Investor’s Dilemma

Context

A growth investor aims for high returns by investing primarily in technology stocks, which have shown significant appreciation over the last five years. However, due to the rapid growth in technology, the asset allocation has shifted dramatically from 70% technology and 30% bonds to 90% technology and 10% bonds.

Due to this shift, the portfolio has become riskier than intended, potentially exposing the investor to higher volatility.

Example

To rebalance, the investor decides to sell 20% of their technology holdings and reinvest the proceeds into bonds. The initial investment was:

• Technology Stocks: $700,000
• Bonds: $300,000

After selling $140,000 worth of technology stocks and purchasing $140,000 in bonds, the new portfolio composition is:

• Technology Stocks: $560,000
• Bonds: $440,000

This adjustment returns the asset allocation to 56% technology and 44% bonds, aligning more closely with their risk tolerance while potentially improving performance stability.

Notes

• Variation: If the investor had waited longer to rebalance, the technology stocks might have faced a downturn, leading to a larger loss due to the higher concentration in one sector.
• Key Takeaway: Rebalancing can mitigate risk and maintain growth objectives.

Example 2: The Retiree’s Income Strategy

Context

A retiree has a conservative portfolio consisting of 60% bonds and 40% dividend-paying stocks. As the market fluctuates, the value of the stocks rises significantly, shifting the allocation to 50% bonds and 50% stocks. The retiree is concerned about maintaining stable income.

Example

To rebalance, the retiree sells $50,000 worth of stocks and reallocates it into bonds. The original portfolio was:

• Bonds: $600,000
• Dividend Stocks: $400,000

After the adjustment, the new portfolio looks like:

• Bonds: $650,000
• Dividend Stocks: $350,000

This change reverts the allocation back to 60% bonds and 40% stocks, ensuring a stable income stream during retirement years while still participating in stock market growth.

Notes

• Variation: If the retiree had not rebalanced, the increased stock exposure could have led to a higher risk of capital loss during a market correction.
• Key Takeaway: Rebalancing helps maintain income stability in a retirement portfolio.

Example 3: The Young Investor’s Long-Term Growth

Context

A young investor starts with a balanced portfolio of 50% equities and 50% fixed income, aiming for long-term growth. Over time, due to market performance, the equities grow to 70%, increasing the portfolio’s risk profile beyond the investor’s comfort level.

Example

To rebalance, the investor sells $20,000 worth of equities and reinvests it in fixed income. The original allocation was:

• Equities: $500,000
• Fixed Income: $500,000

After rebalancing, the new allocation becomes:

• Equities: $480,000
• Fixed Income: $520,000

This adjustment returns the allocation to 50% equities and 50% fixed income, ensuring that the investor can withstand market volatility while still pursuing growth.

Notes

• Variation: An alternative strategy could have been to maintain a 70% equity allocation during a bull market to capitalize on growth, but this would have increased risk.
• Key Takeaway: Regular rebalancing helps young investors maintain their risk tolerance while aiming for growth.