Key takeaways:

• Portfolio rebalancing is used to manage risk exposure, ensuring one portfolio still aligns with an accepted level of risk

• It is important to regularly review your portfolio and the weight of holdings in your portfolio

• Investors must weigh up the trade-off between letting a winning position run and the opportunity cost from rebalancing a portfolio 

One of the common traps that investors fall into is to put all their eggs in one basket, rather than diversifying their portfolio. It may not even be one stock. Instead, it might be a series of holdings all in the one sector, or leveraged to the same theme. 

Combined with periods of market volatility, investors with a concentrated amount of capital in a small number of holdings face greater risk across their portfolio. While this may prove favourable when things work out well, it can also result in magnified losses if the tide turns.

This sort of complacency is something that investors should learn to manage, or at least have the appropriate tools to manage. Portfolio rebalancing is one strategy that can help you keep your portfolio on track, control long-term risk exposure, while also harnessing potential for returns via countercyclical trades.

What is Portfolio Rebalancing?

In simple terms, portfolio rebalancing is the act where an investor adjusts the allocation or weight' of individual assets or stocks in their portfolio to match the original allocation as set out by an investor with regards to their risk and reward profile.

This strategy ensures that a series of investments do not deviate away from an investors' goals and objectives. The aim is to bring asset allocations back into line with one investment preferences.

Why Rebalance Your Portfolio?

The main purpose of portfolio rebalancing is to ultimately manage your overall risk exposure.

If you are one to not follow your portfolio all that regularly, you might find that one day your portfolio is no longer a reflection of what you originally invested in. Furthermore, you might find that the holdings in your portfolio, or the weight of the holdings in your portfolio, no longer align with your goals, attitudes, or life circumstances.

In many respects, if you do not rebalance your portfolio from time to time, you are entirely reliant on the market to shape your risk exposure. And if there is one thing that investors should be cognisant of while investing in shares, it is crucial that investors do everything within their means to consider and manage the risks that exist.

If you find that your portfolio sits outside your goals or risk appetite, you may well face a situation where you are overexposed to individual stocks or certain sectors. Should volatility arrive in these areas and market sentiment deteriorates, you face the prospect of a bigger hit.

How to Rebalance Your Portfolio

The first step is to make sure that you are actively monitoring your holdings on a regular basis. 

Whether it be every fortnight, once a month, or every quarter, review the size and performance of your holdings, taking into account the weight that each stock represents within your portfolio. You may also go one step further by considering the weight of stocks from various sectors within your portfolio.

From here, if you identify that an individual stock, or a cohort of stocks from a particular sector make up an excessive portion of your portfolio - and this will vary depending on your goals and risk appetite - you might be inclined to review whether you should reduce, sell, or buy stocks in order to adjust the allocations of each holding in your portfolio. 

Perhaps it is the case that you wish to realign portfolio allocations to their original levels. 

If you add new funds to your account, those funds might be deployed elsewhere to dilute the size of an oversized' holding. Alternatively, you might reduce your exposure to one holding in order to redeploy that capital elsewhere and rightsize' the individual weight of each holding in your portfolio.  

Periods of significant market volatility can distort the weight of holdings within a portfolio, so it is important to consider the broader context that serves as the basis for your portfolio review. 

If a stock has become too large' in your portfolio by virtue of the fact that other stocks have significantly underperformed, you may decide that it would be inappropriate to rebalance your portfolio.

Practical Outcomes of Portfolio Rebalancing

While investors may be inclined to let their winners run, there is also a school of thought that it never hurts to take profits along the way.

In this sense, if an investor chooses to cut their exposure to a stock that represents a large weight of their portfolio, they may be managing their risk, but they also face the potential outcome where they limit the upside or potential profits from that position if it continues to perform well.

Nonetheless, many investors opt to take some money off the table during circumstances including but not limited to:

• When a certain stock outperforms in a short period of time

• Where an investor decides a stock races ahead of its intrinsic or fundamental value

• Stocks with higher risk profiles

• Companies with low-growth outlooks

In these cases, investors are sometimes inclined to redirect sales proceeds into stocks that they believe are either undervalued, offer a more defensive profile, or where increasing the weight of another holding would provide desired exposure to a certain industry, sector, or theme.

Final Thoughts

It is not uncommon for investors to have doubts about when to reduce or exit a particular position, especially if that stock has become a large weight in their portfolio thanks to its own success.

However, investors should also be aware that risk management is an important tool for long-term sustainable wealth creation. 

With this in mind, portfolio rebalancing has the potential to serve as a temperature check where investors can reassess their risk exposure, and whether their holdings still align with their goals.