What it is:
Rebalancing is the adjustment to an investment portfolio that realigns the investor's holdings with their targeted allocation of assets.
How it works (Example):
Investors often use an asset allocation method in their investment strategies. Asset allocation is a strategy that distributes investments among various classes of investment vehicles, such as stocks, bonds, and cash. Asset allocation plans differ based on the investor's goals and appetite for risk.
Over time, as the market moves and various investments in an investor's portfolio rise or fall, the value of the investments, and, as a result, the allocation of assets within the portfolio may change.
For example, an investor may allocate no more than 30% of their portfolio in stocks. However, after a rise in the stock market and a fall in bond values, the value of their stock portfolio increased to 36% of their assets. They must adjust or rebalance their portfolio by selling stocks and buying bonds and moving a portion of their assets to cash.
Why it Matters:
Rebalancing allows the investor to prevent his or her portfolio from becoming too risky or too conservative. However, rebalancing may hurt overall returns because the process tends to result in the sell off of better performing assets (i.e., higher yielding stocks) and purchase of underperforming assets (e.g. lower yielding bonds). Therefore, rebalancing should only be done on long term assets (i.e. to qualify for long term capital gain tax treatments) and when the variance from the asset allocation targets are high (i.e., greater than 5%).