Walnut Investing

Information pertaining to investing by Jay Handy

What is portfolio rebalancing and why does it matter?

by Jay Handy, CEO of Walnut Capital Management and SignalPoint Asset Management

When we talk about Walnut Investing, we frequently talk about portfolio rebalancing and the value you gain from the process.

What is portfolio rebalancing anyway, and why does it matter?

A typical portfolio contains different kinds of assets, such as equities, bonds, and cash, called asset classes. Equities tend to be higher risk (with higher potential gains) than bonds. Bonds tend to be higher risk (with higher potential rewards) than cash. When creating a portfolio, an individual investor or financial advisor will typically assess the investor’s risk tolerance and goals and allocate assets to match those goals.

Sample Portfolios with Assets Allocated for Different Investors

younger-investor     older-investor

For example, if an investor has 30 years to save for retirement, the proportion of equities in their portfolio may be much higher than the proportion of equities in the portfolio of someone with a five-year timeline. Putting 68 percent of a portfolio into equities is likely to be a lot less risky at age 25 than it is at age 70.

Once a portfolio is created and funded however, the different assets earn different returns over time. Left untended, the asset allocation begins to change as different segments perform better or worse than others. If the stock market is having a good year, the proportion of equities in the overall portfolio will tend to creep up over the year, creating a riskier portfolio than the investor desired.

Hypothetical Portfolio Growth Over One Year (Above Average Stock Market Performance)

initial-balance     balance-1-year-later

In the hypothetical example above, in a year of above average stock market performance, the equities portion of the portfolio grew faster than the bonds and cash portions of the portfolio. As a result, without rebalancing, the portfolio has become increasingly risky over the year. Without intervention, the portfolio will likely move further and further from the original asset allocation strategy.

If you’re managing your own money, the best thing to do is check in on your portfolio frequently and modify how you buy and sell when one segment outperforms another. For example, you might move gains from equities into bonds and cash to return to the original allocation strategy.

If that sounds like more involvement than you want, you can of course use a traditional financial advisor or a service like Walnut which will frequently rebalance your portfolio for you.