Hi everyone, here is another post from my series 'Education for new investors'. I will be sharing my knowledge on topics surrounding investing and readers do not require prior financial background to understand the posts.
❓ What is meant by "Portfolio rebalancing" ❓
I am sure you will be familiar with the concept of a portfolio. Just to refresh, a portfolio is usually composed of different asset class such as Stocks and Bonds with a defined proportion of 50% Stocks and 50% Bonds for example.
But the idea of Portfolio rebalancing, is to adjust our portfolio and make sure that it remains at 50% Stocks and 50% Bonds or any setting that you prefer (90/10, 80/20, 70/30, 60,40, 50/50, 40/60, etc...).
🤷♂️ I have decided the initial proportion I wanted to invest in each asset class, why would I need to adjust it ? 🤷♂️
Let's explain with an example.
Let's say that we are the 1st January, and we make an arbitrary decision to invest $50 in Stocks (regardless the company) and $50 in Bonds (regardless the bond chosen). Stocks and Bonds, each have their own risk and return ratio.
After a year, we have had a profit of +50% on our Stocks, and neither profit or loss on Bonds.
So after a year, the investment value in Bonds remained at $50.
However, our Stocks have been profitable by 50%. So the value of our investment in Stocks went from $50 to $75.
Now the total value of Stocks and Bonds on the 31st December is at $50 + $75 = $125.
But now we are about to start a new year and we will have to rebalance our portfolio, as we have $75 in Stocks and $50 in Bonds and it does not match the initial setting we have decided on 1st January which was to invest 50/50 equally in Bonds and Stocks.
🤷♂️ How do we rebalance our portfolio then ? 🤷♂️
It is very easy. 😁
Following the previous example, as of 31st December, you now have a portfolio with a total value of $125. But as we are going through the portfolio rebalancing, we have decided that our initial setting should be and remain at 50/50, and because of this we are supposed to have $62.5 in each asset class.
So from the Stocks we will have to reduce the total amount by $12.5 from $75 to $62.5, and increase by $12.5 our Bonds investment, from $50 to $62.5, to keep our initial setting of 50/50.
Just to let you know, no additional investment has been made at this point, we just transferred the surplus from Stocks and added it to Bonds.
These are the fundamental starting points to learn about the concept of portfolio rebalancing.
If you liked this post, please stay tuned for more posts within the series and feel free to leave a comment in the section below. 👍🏻👍🏻