Diversification in a portfolio is crucial for investors. It can not only help them reduce their risks but can also increase their returns. There are several strategies that can help them achieve this goal. Most simply, investors can diversify within their asset class. However, that does not reduce their exposure to specific risks. For that, investors may need to use an asset allocation strategy.
What is Asset Allocation?
Asset allocation is an investment strategy through which investors include investments from several asset classes in their portfolios. This strategy is highly beneficial for protecting investors against unsystematic risks that are specific to an asset class. Usually, investors may divide their investments into equities, fixed-income instruments, or cash and cash equivalents.
Investors need to employ an asset allocation that caters to their needs. For that, they need to determine a portfolio mix. This mix establishes the division of their funds into different asset classes. Over time, each investment will earn varying returns. Therefore, the weighted mix of each asset class may differ after a specific time. In these cases, investors will need to consider rebalancing their portfolios.
What is Rebalancing a Portfolio?
As mentioned, investors will establish a portfolio mix that defines how much they invest in each asset class. In some cases, however, this mix may change over time. Therefore, investors will need to rebalance their portfolios. Rebalancing a portfolio is a process that allows investors to buy or sell assets within their portfolio to revert to their original portfolio mix.
Rebalancing a portfolio is crucial for investors to stick to their intended portfolio mix. The portfolio mix does not change due to changes in the assets within a portfolio only. Investors can also rebalance their portfolios when their risk tolerance levels or overall investment strategy changes. Due to any of these reasons, investors may choose to rebalance their portfolios.
How does Rebalancing a Portfolio work?
Portfolio rebalancing allows investors to restructure their portfolios due to any of the reasons stated above. It is a part of the asset allocation strategy that investors use to protect themselves through diversification. Usually, investors have a defined portfolio mix that is a part of this strategy. However, when this mix changes, investors will need to reestablish the original mix.
For that, investors need to work out which asset classes exceed their required limit. Once they do so, they will sell enough assets from that class to revert to the required limit. Similarly, they can also identify asset classes that are below the expected weight. For these classes, investors will buy more assets to raise the mix to the required limit.
What is the importance of Rebalancing a Portfolio?
Investors can get several benefits by rebalancing their portfolios. Asset allocation strategy primarily focuses on diversifying investors’ risks. For that, their portfolio must include an optimal mix of assets from various asset classes. Portfolio rebalancing can help them reestablish that mix when things change.
Portfolio rebalancing can help investors reduce their portfolio risks. Investors can either use this strategy after a specific time interval or when their portfolio becomes unbalanced. It also compels investors to sell their investments when they are at a high point and buy low ones. In the long run, portfolio rebalancing helps investors focus on long-term goals.
Conclusion
Asset allocation is an investment strategy that allows investors to diversify their portfolios. It does so by dividing their portfolios into various asset classes established through a mix. However, this mix may change due to various reasons. For that reason, investors will need to rebalance their portfolios. Portfolio rebalancing is a technique used by investors to bring their portfolios back to their established portfolio mix.
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