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Why Do We Rebalance?
Rebalancing is a crucial aspect of investing, but why is it necessary? There are various reasons why you might need to rebalance your portfolio, and the first one is implementing changes to your investment objectives. This might seem like a fancy textbook definition, but it’s essential to understand how your goals affect your portfolio allocation and why you need to rebalance.
When you start investing, your primary objective is likely to get rich or build wealth. This goal will influence your portfolio allocation, and you might allocate 80 to 90 percent of your investments to get wealthy and only 10 percent to stay wealthy. However, as you progress and reach a certain level of success, your objective might shift to staying wealthy. This change in mindset will require a change in allocation, and you might need to allocate 70 percent of your portfolio to stay wealthy and 30 percent to get wealthy.
Your goal also impacts your risk tolerance, and your appetite for risk decreases as you get older. In your 20s, you might have a high tolerance for risk, and you’re more aggressive with your investments. However, as you approach retirement, your appetite for risk declines, and you’re more concerned about the stability of your portfolio value.
Rebalancing allows you to reflect these changes in your portfolio allocation and risk tolerance. Target date retirement funds and index funds are useful in this regard, as they paint a clear picture of what should naturally happen in your portfolio. For example, a 20-year-old’s portfolio might have a heavy equity allocation, but as they get closer to 70, the amount of risk in their portfolio should decrease.
In conclusion, rebalancing is necessary to ensure that your portfolio reflects your investment objectives and risk tolerance. As you progress through life and your goals change, your portfolio allocation should reflect those changes to achieve your financial objectives.
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