When you start investing, you should make an investment strategy. Among other things, you should decide how much of your portfolio you want in each of the different asset types you want to invest in. This is primarily done to decrease your risk, so your whole portfolio is not greatly affected by a loss on one investment.
As time passes by, the result of your investments will start to show up in your portfolio. Some will be good investments and they will have increased in value. Some might have turned bad and decreased in value. Others will have gotten just the expected return. The result is that the split among the different assets that you decided on when you started your investment will no longer be the same as the split the portfolio has developed. Therefore, your portfolio's risk is different from your initial decision about what kind of risk you could accept from your investments. This is, of course, not so good and it is the main reason for rebalancing your portfolio.
Let's look at an example to try to clarify this. You might initially have decided to invest 40% in a US stock mutual fund, 20% in an international stock mutual fund and 40% in a bond mutual fund. Now the stocks have done very well, and have gone up a lot. There is 50% in US stocks, 30% in international stocks and only 20% in bonds now. This would not be uncommon, as stocks tend to increase more in value than bonds given enough time. The effect is that you now have a riskier portfolio, as the bonds (with lower risk) have become only 20% of your portfolio instead of 40%. If your risk preference is still the same, you should move some of your investments from the stock funds to the bond fund, so you re-establish your initial portfolio split.
Before you do this, there are some things you should be aware of. There might be some expenses related to adjusting your portfolio, so you should not rebalance your portfolio every day. That will not be efficient and it will require a lot of your time. Anyway, it is not so important if your portfolio is not very different than your initial portfolio. The risk will not be significantly different. Another important aspect is the tax issue. When you sell your investments, it might result in a tax on your profits. Of course, you want to lower your taxes as much as possible, so tax should be taken into consideration when you make a decision to rebalance your portfolio. As a rule of thumb, it might be good to rebalance your portfolio every year. But make sure to take your individual conditions into consideration when making your decision.
Brian_Ullitz
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