Portfolio rebalancing is the process of keeping the original asset mix or proportions within a portfolio the same over time. Rebalancing is seen as important because it keeps the portfolio at the desired risk level and asset allocation. This stability allows for long-term goal planning.
Portfolio rebalancing brings a collection of investments back to its intended or updated configuration. This is required because asset prices rise and fall over time, resulting in those assets becoming a smaller or larger part of the overall portfolio. As this happens, the portfolio deviates from the originally selected portfolio allocation and risk tolerance.
For example, assume an investor has a £50,000 portfolio, and they invest half in stocks and half in bonds, and they want to maintain this ratio over time. Assume the stocks increase by 20% in a year and bonds increase by 3%. The stocks are now worth £30,000, and the bonds are worth £25,750, making the portfolio valued at £55,750. And stocks now represent almost 54% of that.
Over time, if this trend were to continue, stocks would continue to account for more and more of the portfolio value. This is not the original goal of the portfolio, so to rebalance it back to 50/50, the investor could sell some stock and buy more bonds.