Why Rebalancing is Important for International Investors

How to Rebalance a Portfolio to Maintain Asset Allocation

Getty Images / Monty Rakusen.

Suppose that you build a portfolio that has 75% exposure to developed markets, 20% exposure to emerging markets, and 5% exposure to bonds and forget about it for a year. You log in to check on the portfolio a year later and find that the mix has changed to 50% emerging markets, 45% developed markets, and 5% bonds – a significantly riskier asset allocation! The outperformance of emerging markets threw off the mix and added risk to the portfolio.

The good news is that there’s a simple strategy designed to reduce these risks – rebalancing.

What is Portfolio Rebalancing?

Many international investors build portfolios with specific asset allocations that are optimized to meet their investment objectives. Unfortunately, these asset allocations are only perfect at the moment that they are created, since asset prices are constantly in flux. Changes in the price of assets changes the percentage of the portfolio that they represent, which means that investors must rebalance their portfolios over time to maintain the right allocations.

For example, suppose that you’re stuck in the aforementioned scenario where you’re over-exposed to emerging markets after a year. The portfolio could be rebalanced by selling emerging markets and buying developed markets until the desired asset allocation is reached. Alternatively, you may decide to rebalance the portfolio by simply diverting any new capital away from overweight sectors and into underweight sectors.

A key mistake made by novice investors is holding on to overweight positions since they have been top performers. Of course, experienced investors know that past performance is not a reliable indicator for future performance. Investors should instead take a look at the risk associated with the asset class in general and ensure that it’s allocated at the right levels for their portfolio rather than focusing solely on performance metrics.

Problems with Rebalancing

The bad news is that there are costs associated with rebalancing a portfolio. For example, investors must often pay a commission when buying and selling assets and there’s always some level of slippage in transactions. These costs may seem minute in any individual rebalancing transaction, but they can quickly add up over time. In fact, these kinds of costs are one of the principal reasons that individual investors underperform the market.

The good news is that there’s a logical solution to this problem. Rebalancing only needs to occur when a portfolio has drifted too much from the desired asset allocation. In general, investors should consider rebalancing when their portfolio has drifted by more than 3%, which tends to be a relatively rare occurrence. The biggest mistake that investors make is rebalancing too frequently and incurring significant transactional costs.

There are also tax implications associated with rebalancing a portfolio. After all, investors must pay capital gains tax on any realized gains from selling an asset. In some cases, investors may want to consider simply not contributing any new funds to an overweight asset class rather than selling in order to avoid incurring these costs.

In other cases, waiting to rebalance an overweight sector may involve more risk than incurring the tax.

Automated Rebalancing

There are many solutions that automate the rebalancing process in order to make it easier for investors. For example, Betterment and WealthFront are two robo-advisor that automatically maintain balanced portfolios in the most cost-effective manner for hands-off investors. These services provide an idea of how far off the portfolio is and then take action when the drift goes too far by either selling assets or strategically diverting new contributions.

Many other standalone solutions can take in portfolio data and recommend actions to rebalance the portfolio. Microsoft Excel plug-ins tend to be the most popular way for individual investors to rebalance their portfolios, since many software-as-a-service solutions target registered investment advisors (RIAs).

For example, MoneySense’s free Excel tools provide an easy way to accomplish a rebalancing for most individual investors.

The Bottom Line

Rebalancing a portfolio is vital to ensuring that asset allocations remain in line and investors avoid taking on excessive risk. While the principle is simple, the act of rebalancing involves a lot of different types of costs that should be carefully analyzed. The good news is that there are software solutions designed to account for these costs and help investors make the right decisions.