What is rebalancing and should you be doing it? In this blog, I explain how rebalancing can sometimes help or hurt your portfolio performance in the long run.
Rebalancing simply means realigning the assets’ weightings back to our target structure of the portfolio. This is best-shown through an example. Let’s say we have $5,000 to invest and we decide to buy five cryptocurrencies: Bitcoin, Ethereum, Ripple, Litecoin, and Dogecoin (just for fun). Let’s also presume that we will follow an equal-weight strategy, meaning that each asset will have an equal allocation in our portfolio: since there are five of them, each one will represent 20% (or $1.000) of the portfolio.
Say we now go on a vacation for a month and we have completely forgotten about our portfolio, and when we return, we see the news titled: “Bitcoin has reached it’s highest price point in 2019!”. We immediately remember that we had invested in Bitcoin and go check if we’ve actually made any money. We realize that our portfolio has grown to $6,430 — and we have just covered all of the expenses of our vacation. Yay! But since some of the assets performed exceptionally well in the previous month, they now consequently also have a higher weighting in the portfolio. For example, Bitcoin jumped from $1,000 to $1,800 and its weighting also rose from the initial 20% to the current 28%.
We now decide to rebalance our portfolio. Now, we have more money invested in the portfolio ($6,430 compared to the initial $5,000) and, after rebalancing, each asset is worth more ($1,286 per asset).
Two things happen when we rebalance:
1) We realize the gains and cover the loses. This is shown in the chart above. Bitcoin, for instance, performed very well in the previous month, therefore we realized a gain of $514 — this profit is then taken out of Bitcoin’s position and distributed among other assets that did not perform so well, for instance, Dogecoin.
2) We increase the weightings of our worst performers and reduce the weightings of our best performers. Sometimes, this can make a substantial change in how well the portfolio performs. For instance, prior to rebalancing, Bitcoin had $1,800 invested in it and if Bitcoin would continue to outperform the market, we would quickly possess $2,000 of unrealized gains. However, if we rebalance our portfolio and realize Bitcoin’s gains, we have to wait for it to first grow back to $1,800 and then to $2,000 (assuming we don’t rebalance the portfolio in the meantime).
On the positive note, we do get rid of the concentration risk (exposure). This is the risk of having too much money invested in a single asset in the portfolio. Again, going back to Bitcoin: if we hadn’t rebalanced the portfolio, Bitcoin would have had 28% allocated in it. Let’s imagine, we would let it grow to 45% of the total allocation. If some bad news broke out and Bitcoin started to free fall, our portfolio value would have followed the same trajectory, since Bitcoin would represent the majority of the portfolio.
Now, concerning the big question, “Should you rebalance or HODL”, I decided to prepare a separate article where we will learn from the past, taking a closer look at which of the two options turned out as the most profitable in the bull run of 2017, in the bear market of 2018, and during the “latest“ bull-run of 2019.
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DISCLAIMER: This article is for informational and discussion purposes only and does not constitute a marketing message, an investment survey, an investment recommendation, or investment advice. The article was prepared exclusively for a better understanding of market dynamics.