Portfolio rebalancing is a common strategy in long-term investing. As your portfolio grows over time, some investments will return better than others in different time periods, and vice-versa. Rebalancing your portfolio involves selling a small fraction of the investments that have appreciated in value to buy more of the investments that have depreciated in value in that same period. This way, you can aim to buy low and sell high across all your investments each year (or in whatever period you decide).

Some investors may do this for the ETFs they are invested in, whereas others may have a few single stocks of shares that they may need to consider as the company grows (or declines) in value.

For example, NVIDIA has grown from the world’s 1000 ^th largest company to the world’s most valuable company over the last 10 years. If you held NVIDIA at the same fixed percentage in your portfolio, you wouldn't have benefitted from it's growth as it grew in value and in turn would have increased the percentage in your portfolio. This is because, in this specific example, the company itself outperformed the rest of the market. Similarly, if you held eBay at the same percentage in your portfolio over the last 10 years, and didn't reduce the percentage that was allocated to the company, you would have lost a lot more monitary value over the years These two examples really depend on the percentage these companies take up in your portfolio, as it's important to understand your risk tolerance and what percentage you want to allocate to individual companies.

Of course, these two examples are highly specific case studies, and not endorsements or criticisms of either share. No-one can predict the movements of the share market – let alone the performance of specific shares. Even so, these examples demonstrate how portfolio rebalancing can negatively impact specific shares as they fluctuate.

With that said, many long-term investors believe that portfolio rebalancing is a sound approach for more diversified assets, like exchange-traded funds . B elow, we detail some common ways to integrate portfolio rebalancing into your investment strategy.

Portfolio rebalancing summary

Definition : Portfolio rebalancing is the process of realigning the weightings of your assets in your portfolio. This involves periodically buying or selling assets to maintain your desired asset allocation.

Purpose : The main goal of rebalancing is to manage risk and ensure your portfolio stays in line with your investment objectives and risk tolerance. As markets fluctuate, some investments may grow faster than others, causing your portfolio to drift from its original allocation. Rebalancing brings it back to your intended risk/return profile.

Why Rebalance?

1. Risk management : Over time, as some investments grow faster than others, the risk profile of your portfolio may shift. For example, if stocks perform well, their increased value can mean your portfolio becomes overweight in equities, increasing your exposure to market volatility. Rebalancing mitigates this risk by selling overperforming assets and buying underperforming ones to maintain the desired risk level.
   
2. Goal alignment : This entails working to keep your portfolio aligned with your financial goals, whether they are growth, income, or capital preservation. For example, if you are nearing retirement, you may want to shift your portfolio towards more conservative investments like bonds to reduce risk.
3. Discipline : Ideally, rebalancing encourages a disciplined investment approach, avoiding emotional decisions based on market fluctuations. This discipline can prevent you from making impulsive decisions that could harm your long-term investment strategy.

Investments for portfolio rebalancing

It may not be appropriate to rebalance every investment in a strict periodic fashion. However, as mentioned earlier, portfolio rebalancing has historically been popular for more diversified assets, like exchange-traded funds (ETFs). ETFs are baskets of different investments, such as stocks or bonds, that you can buy and sell on the stock market. They allow you to invest in many different things at once, which can spread out your risk. ETFs can be traded just like regular stocks throughout the day, and they usually have lower costs compared to other types of investment funds.

Firstly, ETFs rebalance automatically, internally. ETFs rebalance automatically through a process called "reconstitution." Here's how it works in simple terms:

1. Following an index : Most ETFs track a specific index (like the S&P 500 ). The index is managed by a separate company that decides which stocks or assets should be included.
   
2. Regular updates : Periodically, the index provider reviews and updates the list of assets to reflect the current market or sector. This could be quarterly or annually.
   
3. Automatic adjustment : When the index changes, the ETF adjusts its holdings to match the new composition. The fund managers buy and sell assets as needed to ensure the ETF aligns with the updated index.
   

By doing this, ETFs seek to maintain their intended exposure to the market or sector, ensuring they continue to meet their investment objectives without requiring investors to manually rebalance their portfolios.

Secondly, they are liquid & diversified by nature, meaning the main value changes they’re exposed to are systematic value changes of the underlying market index or sector. As such, their value changes are more systematic and reflect overall market or sector performance. In contrast, individual stocks are subject to idiosyncratic risks – company-specific factors that can cause significant volatility and value-changes that aren’t accounted for in fixed percentage allocations.

Some useful further reading on ETFs can be found below:

• How to choose the right ETF for me
• Diversified ETFs or DIY
• The Ultimate Guide to Diversified ETFs for Australians

Other investment vehicles that can be appropriate for portfolio rebalancing are listed investment companies (LICs), managed funds and real estate investment trusts (REITs).

Rebalancing strategies

1. Time-based rebalancing : Set a specific interval (e.g., annually, semi-annually) to review and rebalance your portfolio. This method is straightforward and ensures regular attention to your investments.
   
2. Threshold-based rebalancing : Rebalance only when the allocation of an asset class deviates by a certain percentage (e.g., +/- 5%) from its target. This method is more responsive to market conditions and can be more efficient in maintaining your desired risk level.
3. Automated, incremental rebalancing : Some long-term centric investment platforms (such as Pearler!) enable investors to set target weights and then make new investments into the most underweight investment each time. This enables cost-effective, automated rebalancing as it minimises transaction costs.
4. D ollar-cost averaging: Also known by its abbreviation DCA, dollar-cost averaging traditionally involves consistently investing the same amount every week, month, or quarter. DCA seeks to ensure you invest consistently; therefore, you can buy more when the market is low, and less when the market is high. It also means you can rebalance your portfolio by choosing how much you want to invest in individual assets.
   

Cost considerations

Transaction fees : Be mindful of trading fees and commissions when buying or selling assets. Frequent rebalancing can lead to high transaction costs, which can erode your returns.

Tax implications : Understand the tax impact of selling appreciated assets, including capital gains taxes . In taxable accounts, selling assets can trigger capital gains taxes, so seek advice from a certified tax accountant if you're unsure about this.

Opportunity costs : Consider the potential opportunity costs of selling assets that may continue to perform well, or buying assets that may continue to perform poorly. This is particularly relevant if your investments aren’t well-diversified.

Diversification

Sector diversification : Spread investments across different sectors to reduce sector-specific risks. Diversification between sectors helps manage risks associated with any single industry.

Geographic diversification : Include international investments to mitigate country-specific risks.

Asset Class Diversification : Balance between different asset classes (stocks, bonds, cash, real estate, commodities) to spread risk and potentially reduce volatility.

Pulling it all together

Rebalancing your portfolio may be worth considering if you’re a sharemarket-heavy investor who is already doing all the fundamentals. Like any investment strategy, read up on it and contemplate whether it's right for you before committing. And if you're still unsure, consider speaking with a registered financial adviser.

Happy investing!