Sound investing is about having the right investment strategy. It’s not about short-term tactical trading or speculative trend-chasing.

However, in one key sense there may be good reason to tinker periodically with your investments by ‘rebalancing’ your portfolio. Some all-in-one multi-asset funds, like our LifeStrategy or Target Retirement fund ranges, do this automatically. But if your portfolio is made up of different funds, you may want to consider altering your mix manually – say, at the start of each calendar year or ahead of the tax year, or even each quarter, depending on your preferences or how markets behave in the interim.

What precisely do I mean by ‘rebalancing’ and why does it matter?

It’s all to do with the first two of Vanguard’s four investment principles: goals and balance. (If you want a refresher on these principles, here’s a short video).

Research has shown that it is your mix of assets that will most likely determine your long-term investing success¹. So you need the right balance of shares and bonds to enable your savings to work as hard for you as possible over several years, if not decades. Deciding what that exact balance should be is a function of your goals, however vague they may be.

Time is of the essence

Thinking about your investment mix in terms of your personal goals, at its essence, boils down to this: the further away they are, the more you should consider having shares. And vice-versa. This is because shares, historically, tend to generate a higher return than bonds but also have a greater propensity to jump around in price, leaving you more exposed, potentially, in a market downturn.

So the more time you have, the more easily you should be able to ride out adverse market moves and benefit from that potentially higher long-term return. It’s why, if someone is close to retirement, they should probably have more bonds in their investment portfolio and why, if they’ve just started out on their career, they might want to consider having just shares instead.

The one proviso is that some people are more cautious than others and may be less willing to take risks with their money. So your approach needs to be finessed based on your personal risk preferences. Broadly speaking, though, time to target is the key factor.

But why the need for re-balancing? Two reasons: time doesn’t ever stand still, and nor do markets.

So as you get older and closer to that time when you might retire, it makes sense to think about altering your pension fund investments. It’s something our Target Retirement Funds, specifically, do for you automatically. 

But, more generally, if some investments perform better than others, then the ratio of assets in your portfolio will inevitably change too. If you’re targeting a 60:40 split between shares and bonds, say, and your stock market funds grow by 10% on average in value one year, while your bond funds slip by 10%, then that ratio will have changed to something more like 65:35. You’re now inadvertently ‘overweight’ shares and ‘underweight’ bonds.

The change might seem small but it’s important to understand that this drift away from your original allocation can build and build, if left unchecked. The diagram below illustrates the rebalancing process.

Guarding against return chasing: rebalancing

Source: Vanguard.

Redress the balance

If, in the original example, you wanted to get the portfolio back on target you could sell 3.5% of the strong-performing equity fund shares and reinvest the money in bond funds.

Of course, that might sound counterintuitive to a lot of people. In my experience as an adviser, clients would often balk at the suggestion of adding to the assets they had that were falling at the expense of their best-performing investments. But then the objective of portfolio rebalancing is to minimise risk as well as maximise long-term return, which can be difficult to get across when markets are doing well but will protect you given those high-flying markets can also go down.

In any case, it’s not the only rebalancing option open to you. Another way to redress the balance would be to direct any new cash contributions to your savings to those fund holdings that have underperformed.

It’s something to think about now we’ve entered the last quarter of the tax year, especially if you have yet to make full use of your annual tax allowances, whether for your individual savings account (ISA) or self-invested personal pension (SIPP).

¹ 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.)