The Importance of Rebalancing Your Portfolio

Rebalancing is the process of returning values of a portfolio’s asset allocations to the levels predetermined in your investment plan.

This is because these allocated weightings are intended to match your risk tolerance with your desired return. Aside from these fundamentals, rebalancing a portfolio at regular intervals provides numerous other benefits to your portfolio, such as:

• Prevents overexposure to specific risks
• Optimises Risk-Return
• Adapts to changing goals and objectives

Overexposure mitigation

One of the key benefits of portfolio rebalancing is its role in preventing overexposure to a single asset class or sector, a risk that increases over time due to risk drift. Risk drift occurs when the relative performance of assets within a portfolio causes the original allocation to shift. As some assets grow faster than others, their weight in the portfolio increases, altering the risk and return profile in unintended ways.

This imbalance can lead to overconcentration, where too much of your portfolio is tied to one type of investment, such as equities, technology stocks, or a specific geographic region. While this might seem like a good problem to have when markets are rising, it becomes a significant risk when markets turn.

Optimising risk-return

By periodically selling high-performing assets and buying those that have underperformed, portfolios may benefit from “buying low and selling high.” This can help capitalise on market inefficiencies and corrections, potentially enhancing long-term, risk-adjusted returns.

Let’s take the past 12 months of the Australian equities and the 2 Year Australian Government Bond markets, for example. If you invested $10,000 into each asset, a 50/50 split, on June 1st 2024, over 6 months, you would have seen a 10.31% return on equities and a drop in value of 6.17% in the Australian 2 Year Government Bonds. At this point, your Equities now contribute 54.04% of your portfolio’s value, and your Bonds contribute 45.96%. Here, your portfolio is more reliant on equities and is exposed to equity-specific risks, meaning this would be a time to rebalance back to a 50/50 weighting split. From January 1st, Equities dropped 4.87% and bonds rose 8.92%.

How has your portfolio value changed?

Unchanged Portfolio After 6 Months

Rebalanced Portfolio After 6 Months

As seen above, by readjusting weightings after 6 months, the portfolio scored an extra 0.57% in 4 months.            

Adapting to changing goals and objectives

Rebalancing is more than just a risk management tactic. It is a dynamic strategy that helps investors realign their portfolios with their circumstances, financial objectives, and changing levels of risk tolerance over time, and rebalancing provides a structured way to reflect that evolution. For example, individuals early in their careers typically have a longer time horizon and a greater capacity to take on investment risk. Their primary goal may be to grow wealth aggressively by allocating a larger portion of their portfolio to higher growth assets such as equities or emerging markets. Because they have more time to recover from market fluctuations, they can afford to take on more volatility in exchange for potentially higher returns. On the other hand, someone approaching retirement or already in retirement may prioritise capital preservation and consistent income. Their risk tolerance is generally lower because they are relying on their portfolio to support their lifestyle. In this stage, rebalancing might involve gradually reducing exposure to more volatile investments and increasing allocation to lower-risk, income-generating assets such as government bonds, dividend-paying stocks, or real estate investment trusts.

What makes rebalancing particularly valuable is its ability to account for both external market movements and internal personal changes. Whether you are changing jobs, starting a family, experiencing a health event, or simply revisiting your financial goals, rebalancing gives you the flexibility to ensure that your investment strategy stays aligned with what matters most to you.

Managing tax implications

When rebalancing by selling assets that have appreciated in value, you may trigger capital gains taxes if the assets are held in taxable accounts. The tax liability depends on how much the assets have gained and your personal tax situation. The larger the gain, the greater the tax impact, which can make frequent rebalancing less attractive, particularly for older investors who may benefit from deferring taxes or taking advantage of a step-up in cost basis at death. This trade-off means that the incentive to rebalance for diversification must be weighed against the potential tax cost.

In summary

Rebalancing is a vital component of long-term portfolio management, offering more than just a way to keep asset allocations in line. It plays a crucial role in controlling risk, improving the balance between risk and return, and ensuring that your investments remain aligned with your personal goals and changing life circumstances. Whether it is reducing overexposure to a particular asset class, taking advantage of market corrections, or shifting strategy as you transition through different life stages, rebalancing allows you to remain intentional and disciplined in your approach. While tax implications must be considered, especially in taxable accounts, the long-term benefits of maintaining a well-structured and goal-oriented portfolio often outweigh the short-term costs. Ultimately, rebalancing is not about reacting to every market movement but about staying focused on your objectives and making informed adjustments that support your financial future.

Kurtis Castorina 
Investment Strategy Analyst, Your Future Strategy