Don't be shy, ask ii... is rebalancing throwing good money after bad?

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Derek asks: I understand rebalancing, but how does one actually distinguish between rebalancing (capturing the gains of a good investment and propping up one's lesser holdings "this year" to help reduce risk), and throwing good money after bad by selling good investments to buy extra amounts of investments that are soon going to become obvious turkeys?

Kyle Caldwell (pictured above), Collectives Editor, interactive investor, says: Reviewing your portfolio a couple of times a year is, like other tidy-up jobs, not one that investors are likely to look forward to. But it is necessary, and an important part of the review is making some adjustments to restore the balance of your portfolio. Doing so maintains the level of investment risk the portfolio aimed to achieve when it was first put together. 

Failure to rebalance could result in an investor taking on more risk than they desired and possibly not achieving their financial objectives.

In a nutshell, rebalancing involves taking a look at your winners and converting some of those paper gains into real profits. Some of the proceeds could then be reinvested into areas of the portfolio that have been underperforming, but may soon recover their poise.

For example, let’s consider the two major asset classes – equities and bonds. Over the long run, equities tend to outperform bonds. If the portfolio is not rebalanced for several years, the equities weighting is likely to rise, potentially to a level an investor is not comfortable with. It could turn a low-risk portfolio into a medium-risk or higher-risk portfolio.  

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Of course, there’s always a risk of taking profits from a star performer too soon, particularly when it is significantly outperforming everything else. But, as the percentage weighting of the holding increases in the portfolio, so too does the risk level of your portfolio.

Selling winners and buying losers seems counter-intuitive. However, maintaining an appropriate level of investment risk is prudent, rather than “throwing good money after bad”. I would argue instead that chasing returns is “throwing good money after bad”.

Reinvesting those profits into areas of the portfolio that have been underperforming allows an investor to maintain their risk profile and attempt to ‘buy low’. Of course, the underperforming investments may remain out of form – either temporarily or permanently. As with any investment, it is worth trying to put to the back of your mind its recent performance and ask yourself: would I invest in this today? If it has become a turkey, then it is time to take action.