So you have established an asset allocation strategy that is right for you, but at the end of the year, you find that the weighting of each asset class in your investment portfolio has changed. What happened? Over the course of the year, the market value of each security within your portfolio earned a different return, resulting in a weighting change. Portfolio rebalancing allows individuals to keep their risk level in check and manage risk. What Is Rebalancing? Rebalancing is the process of buying and selling portions of your portfolio in order to set the weight of each asset class back to its original allocation. In addition, if an investor’s investment strategy or tolerance for risk has changed, he or she can use rebalancing to adjust the weightings of each security or asset class in the portfolio to fulfill a newly desired asset allocation. The Consequences Imbalance A popular belief among many investors is that if an investment has performed well over the last year, it should perform well over the next year. Unfortunately, past performance is not always an indication of future performance—this is a fact many mutual funds disclose. Many investors, however, remain heavily invested in last year’s “winning” fund and may drop their portfolio weighting in last year’s “losing” fund, which will alter the original weighting. Remember, equities have historically tended to be more volatile than fixed-income securities, so last year’s large gains may translate into losses over the next year. Continue with Bob’s portfolio and compare the value of Bob’s rebalanced portfolio with the portfolio left unchanged. Hypothetical example shown for illustrative purposes only. Does not represent any actual investment products. This example also does not reflect any tax consequences or investment fees that may result from rebalancing an investment portfolio. At the end of the second year, the equity fund performs poorly, losing 15%. At the same time the bond fund performs well, appreciating 7%, and Treasuries remain relatively stable with a 2% increase. If Bob had rebalanced his portfolio the previous year, his total portfolio value would be $101,803, a decrease of only 2.3%. If Bob had left his portfolio alone with the skewed weightings, his total portfolio value would be $100,864, a decrease of 3.2%. In this case, rebalancing is the optimal strategy. However, if the stock market rallies again throughout the second year, the equity fund would appreciate more and the ignored portfolio may realize a greater appreciation in value than the bond fund. Just as with many hedging strategies, upside potential may be limited, but by rebalancing, you are nevertheless adhering to your risk-return tolerance level. Risk-loving investors are able to tolerate the gains and losses associated with a heavy weighting in an equity fund, and risk-averse investors, who choose the safety offered in Treasury and fixed-income funds, are willing to accept limited upside potential in exchange for greater investment security. Time Period (2 Years) Hypothetical example shown for illustrative purposes only. Does not represent any actual investment products. This example also does not reflect any tax consequences or investment fees that may result from rebalancing an investment portfolio. Blown Out of Proportion The asset mix originally created by an investor inevitably changes as a result of differing returns among various securities and asset classes. As a result, the percentage that you have allocated to different asset classes will change. This may increase or decrease the risk of your portfolio, so let us compare a rebalanced portfolio to one in which changes were ignored, and then we will look at the potential consequences of neglected allocations in a portfolio. Below is a simple hypothetical example. Bob has $100,000 to invest. He decides to invest 50% in a bond mutual fund, 10% in a Treasury mutual fund and 40% in an equity mutual fund. At the end of the year, Bob finds that the equity portion of his portfolio has outperformed the bond and Treasury portions. This has caused a change in his allocation of assets, increasing the percentage that he has in the equity fund while decreasing the amount invested in the Treasury and bond funds. Hypothetical example shown for illustrative purposes only. Does not represent the performance of any actual investment products. More specifically, the above chart shows that Bob’s $40,000 investment in the equity fund has grown to $46,000, an above average increase of 15%. Conversely, the bond fund suffered, realizing a loss of 4%, but the Treasury fund realized a modest increase of 2%. The overall return on Bob’s portfolio was 4.2%, but now there is nearly equal weight on equities and bonds. Bob might be willing to leave the asset mix as is for the time being, but leaving it for too long could result in an overweighting in the equity fund, which historically has been more risky than the bond and Treasury fund. Rebalancing is the process of buying and selling portions of your portfolio in order to set the weight of each asset class back to its original state. How to Rebalance Your Portfolio The optimal frequency of portfolio rebalancing depends on your cash flow, transaction costs, personal preferences and tax considerations, including what type of account you are selling from and whether your capital gains or losses will be taxed at a short-term versus long-term rate. Usually about once a year is sufficient. However, changes in an investor’s lifestyle may warrant a change to his or her asset-allocation strategy. Whatever your preference, here are some basic steps for rebalancing your portfolio: Record. If you have recently decided on an asset-allocation strategy suited for you and purchased the appropriate securities in each asset class, keep a record of the total cost of each security at that time, as well as the total cost of your portfolio. These numbers will provide you with historical data of your portfolio, so at a future date you can compare them to current values. Compare. On a chosen future date, review the current value of your portfolio and of each asset class. Calculate the weightings of each fund in your portfolio by dividing the current value of each fund by the total current portfolio value. Compare this figure to the original weightings. Are there any significant changes? If not, and if you have no need to liquidate your portfolio in the short term, it may be better to keep it unchanged. Adjust. If you find that changes in your asset class weightings have distorted the portfolio’s exposure to risk, take the current total value of your portfolio and multiply it by each of the (percentage) weightings originally assigned to each asset class. The figures you calculate will be the amounts that should be invested in each asset class in order to maintain your original asset allocation. You may want to sell securities from asset classes whose weights are too high, and purchase additional securities in asset classes whose weights have declined. However, when selling assets to rebalance your portfolio, take a moment to consider the tax implications of readjusting your portfolio. In some cases, it might be more beneficial to simply not contribute any new funds to the asset class that is overweighted while continuing to contribute to other asset classes that are underweighted. Your portfolio will rebalance over time without incurring capital gains taxes. Conclusion Rebalancing your portfolio will help you maintain your original asset allocation strategy and allow you to implement any changes you make to your investing style. Essentially, rebalancing will help you stick to your investing plan regardless of what the market does. The tax information contained herein is provided for informational purposes only. AMG Funds does not provide legal or tax advice. Always consult an attorney or tax professional regarding your specific financial or tax situation. Investing involves risk, including possible loss of principal. Diversification does not guarantee a profit or protect against a loss in declining markets. AMG Distributors, Inc., is a member of FINRA/SIPC.