What is portfolio rebalancing and why is it important?

Portfolio rebalancing is when you adjust the proportions of different assets (such as shares and bonds¹) in your investment portfolio to maintain the mix that’s right for you.

This means periodically selling some assets and buying others to get back to the mix of shares and bonds that aligns with your goals and attitude to risk.

In this article, we explain why rebalancing is important and how it works in practice.

Why is the mix of shares and bonds important?

Research has shown that the mix of assets in your portfolio will have the greatest impact on your long-term investing success². Investors typically set a target asset allocation, such as 60% shares and 40% bonds. The right mix for you depends on your goals, how long you plan to invest for and how you feel about risk.

For example, if your goals are far in the future, you might want to invest more in shares. Shares provide higher returns over long periods, but they can also be more volatile, meaning their value can fluctuate a lot.

If your goals are closer, you might want to invest more in high-quality bonds. Bonds are generally less risky and can help protect your portfolio from big market drops.

The longer you’re investing, the more time you have to recover from stock market dips. That’s why people nearing retirement might start shifting more of their investments into bonds.

It’s also important to consider how you feel about risk. Some people are more cautious and prefer to take fewer risks with their money, while others are more comfortable with higher risk for the potential of higher returns.

Why is rebalancing needed?

Different types of investments tend to perform differently to one another. Over time, this can change the mix of shares and bonds in your portfolio.

Imagine you start with a portfolio made up of 60% shares and 40% bonds. If shares grow by 10% in one year and bonds fall by 10%, the split might change to 65% shares and 35% bonds. This means your portfolio has become riskier than you originally intended.

The change might seem small but, if left unchecked, you’ll drift further and further away from your original allocation over time. The diagram below illustrates the rebalancing process.

The rebalancing process

Source: Vanguard.

How portfolio rebalancing works

To get your portfolio back to its original asset allocation, you would sell some of your better-performing investments (in this case shares) and use the proceeds to buy more of your underperforming investments (in this case bonds). Alternatively, you can add new money to the investments that haven’t done as well.

It might seem counterintuitive to invest more money in assets that are falling in value, but the goal of rebalancing is to ensure you don’t stray too far from the right risk level. This helps to protect you when stock markets go down in the future. It also keeps you disciplined, so you avoid making costly mistakes.

The above example shows the rebalancing process when a portfolio has become too risky. But what if your portfolio becomes less risky, shifting from, say, 60% shares and 40% bonds to 50% shares and 50% bonds? Why rebalance in this scenario? First, it ensures you maintain enough risk to allow your portfolio to grow over the long term. Second, by buying more shares, your portfolio will be better positioned to benefit from stock market recoveries.

This is why our all-in-one multi-asset funds – our LifeStrategy funds and our Target Retirement Funds – do the rebalancing for you. 

It’s also why our managed service selects funds based on how you feel about risk and rebalances your portfolio to keep you to the right risk level. If the mix of shares and bonds in your portfolio drifts by more than 5 percentage points, we’ll rebalance the portfolio back to the target mix.

¹ Bonds are a type of loan issued by governments or companies, which typically pay a fixed amount of interest and return the capital at the end of the term.

² Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower, 1995. "Determinants of portfolio performance." Financial Analysts Journal 51(1):133–8. (Feature Articles, 1985–1994.)

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