There is often a dispute among investors as to whether and how often their portfolio should be rebalanced. Among passive and active investors, opinions are divided on this. But how does rebalancing work? Let’s take this article through.
Today, almost anyone can try out as an investor, all you need is the will and the money. Of course, to be successful in a given niche and to start earning money from your investment, it is not enough to invest money anywhere. The investor needs to stick to two main aspects before investing, and they should not be neglected by both mother and newcomer investors.
- The investment portfolio needs to diversify – in other words, to diversify its assets. This should include, for example, traditional currencies, precious metals, digital assets, government bonds, equities, etc. This should be done to ensure that the portfolio is resilient to market fluctuations.
- Rebalance the investment portfolio periodically. Restore the original portfolio structure to support diversification. If this point is ignored, the following may happen: the risky assets will take on a higher share of the portfolio, after which they will have an impact on profits, and the protective assets will not be able to perform their function if the market situation changes.
How it works on the example
- 45% – shares;
- 15% – digital assets;
- 15% – cash (foreign currency);
- 15% – gold;
- 10% – bonds;
After a short period of time, securities become more expensive, and digital assets and precious metals lose their value. As a result, the share of securities rose to 50%, the share of digital currency fell to 10%, and that of dragmetall to 7.5%. At this point, you have to rebalance the portfolio immediately. You have to sell the shares and the cryptocurrency and the gold to buy. But there is also the option of making additional funds to restore the original balance.
Portfolio rebalancing and risk management
Any investor with an investment portfolio cannot predict accurately how the market will behave tomorrow, which will be dynamic and volatile. The right balance between risk and security assets is therefore important. Risky assets can be digital assets and securities, with gold, traditional currency, and government bonds as a sort of stabilizer. Risk assets are the main source of return in the portfolio.
Let’s look at the example
Let’s say an investor has an investment portfolio worth a total of $100,000. The shares are distributed as follows:
- $45 000-securities;
- $15 000-digital assets;
- $15 000-cash (foreign currency);
- $15 000-gold;
- $10 000 – government bonds.
Within six months, the value of securities and crypts increased by 50%, and the price of gold fell by 30%. Foreign currency and government bonds have not changed in price. What assets look like now:
- $67 000-securities;
- $22 500-digital assets;
- $15 000-cash (foreign currency);
- $10 500-gold;
- $10 000 – government bonds.
The investor was able to earn $25,500, and risky assets began to dominate his portfolio. If one chooses to turn a blind eye to rebalancing assets, when the market changes, the risk-taking asset collapse will be felt much more strongly than if the portfolio were balanced.
Now consider another situation, there was a crash. The value of securities with digital assets fell by 50%, and the price of jewellery rose by 30%.
- During the fall of securities, the investor loses $33 750;
- During the fall of the cryptocurrency, $11 250;
- On the growth of gold, he earns $3 150.
So the loss was $41 850. In addition to the loss of profits that could be withdrawn, the investor loses part of its original capital. The investment portfolio falls to $83 650 from the original $100 000.
What can I do?
To avoid such an outcome, it is necessary to keep a balanced investment portfolio, through sales of securities and cryptocurrency, and then by buying gold and government bonds, to restore balance. You have to do this to get back to the original numbers: 45-15-15-15-15-10.
How do you do that? You have to take two simple steps:
- It is necessary to sell securities for $11 025, and the crypt for $3 675;
- Now we are buying currency in the amount of $3 825, precious metals in the amount of $8 325, and government bonds in the amount of $2 550.
The investment portfolio looks like this:
- $56 475-securities;
- $18 825-digital assets;
- $18 825-cash (foreign currency);
- $18 825-gold;
- $12 550 – government bonds.
The reason why it is necessary to do this is simple – the profit that was obtained due to risky assets was transferred to protective assets and because of this it will remain. Due to the fact that the rebalancing was carried out, the portfolio was able to return to its original form, namely to the values of 45-15-15-15-10. There was no need to spend additional money, the purchase of new assets was due to the sale of shares and crypts. If the investor has a desire, he can also contribute new funds for rebalancing.
Let’s return to the scenario when the securities and cryptocurrency market collapsed by 50%, and the price of gold increased by 30%. Now we can see how a balanced portfolio will react to this.
- When the share price falls, the investor loses $28 237,5;
- When the cryptocurrency falls, $9 412,5;
- And with the growth of gold, it earns $5 647,5.
The total loss is $32 002,5. This means that the investor lost $9 847,5 less than he could if the portfolio was not balanced. If you look at this situation in percentage terms, it turns out that the investor lost 6.5% instead of the 16.35% as in the former. And it’s all thanks to a simple rebalancing manipulation.
The main rules of rebalancing
Rebalancing can be carried out with a certain frequency or when one of the assets in the portfolio has reached a certain threshold of its share. But do not abuse the frequent rebalancing, as it is simply unprofitable. The more regularly this procedure is carried out, the more regularly you will have to pay taxes and other commissions. The best option is to rebalance every six months or even a year.
When rebalancing the investment portfolio, it is possible to use not only the earned profit, but also additional money. They can be money that is set aside every month, promotional dividends or coupon income.
Rebalancing your portfolio, as well as diversification, can be a very useful activity for an investor, both novice and experienced. This will minimize risks and make the investment portfolio more stable. But do not forget that the main thing is what tools are used to form a portfolio and how well it is diversified.
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