Automatic rebalancing is the automated buying and selling of investments in a portfolio.
Many retirement-oriented investment plans offer automatic rebalancing. Automatic rebalancing means the portfolio periodically reverts to a specific weighting or percentage of investment types, such as stocks or bonds. This happens with no intervention by the investor.
Automatic rebalancing ensures that the portfolio remains allocated in a way that is in line with your ability to withstand volatility, the up and down movement of investment values.
Many advisors recommend rebalancing once or twice a year, even if the investor does it manually.
Some advisors believe that it’s very unlikely investors benefit from trading. These advisors subscribe to an investment philosophy known as modern portfolio theory (MPT).
MPT argues instead that it is better to leave your money in the market through the ups and downs. According to the theory, investors should consistently add money no matter whether prices are higher, lower or flat.
Investors can, however, try to improve on the portfolio’s expected return through automatic rebalancing.
For instance, you might decide on a 70% stock and 30% bond portfolio. Your advisor sets the account up to auto-rebalance every three, six or 12 months.
Let’s say the stock market does well. The dollar value of the stock portion of your portfolio grows.
Even if bonds are flat the value of the bond portion of your portfolio has fallen relative to your stock allocation. In dollar terms, let’s say, the portfolio’s valuation has become 75% stocks and 25% bonds.
Automatic rebalancing software would sense this change. It resets your allocation back to the original target of 70% stocks to 30% bonds. The software sells a portion of the investments that have done well, taking profits in cash.
The program then redistributes the cash into the portion of the portfolio that has not done as well. In theory, then, the investor has sold high and bought low. Doing so repeatedly over years can lead to a portfolio return in excess of market growth alone.
Investors can choose to rebalance on their own. However, the risk is forgetting to do it, doing it inconsistently or attempting to time the market, which is contrary to modern portfolio theory.
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