Selling a well-performing asset and buying an investment with lower returns may seem counterintuitive, but the objective of rebalancing is to manage risk rather than maximise returns.

A portfolio's asset allocation reflects an investor's goals and temperament—the need for return as well as the ability to withstand market turbulence.

Over time, market fluctuations can affect your asset allocation weightings and change the risk/return profile of your portfolio.

For example, say your target asset mix is a 50/50 split between shares and bonds. You originally invest $3,000 in a stock fund, which buys 20 shares. You invest another $3,000 in a bond fund, which also buys 20 shares. Your $6,000 portfolio balance is split evenly between stocks and bonds, matching your target.

Fast-forward several months in which shares have consistently outperformed bonds. For simplicity, let's say you don't reinvest your dividends or capital gains or make any additional contributions, so you still own 20 shares of each fund.

As a result of market fluctuations alone, your 20 stock fund shares are now valued at $5,000, and your 20 bond fund shares are worth $2,000. Your total portfolio balance—$7,000—is now split approximately 70/30 between shares and bonds, making your portfolio overweight in shares.

This scenario may be profitable right now—after all, you have more money invested in the higher-performing asset class. So what's the danger?

What goes up can come down. If you lose parity with your target asset mix by remaining more heavily invested in shares and they go down in value, you can have more to lose than you anticipated.

Take March 2020 as an example when the Australian share market dropped over 35 per cent at the outbreak of COVID-19, only weeks after the market hit an all time high.

Rebalancing from one asset class to another (in this case, selling shares and buying bonds) can put your portfolio back on track and make sure you're not taking on more risk than you are comfortable with.

Why should investors rebalance?

Selling a well-performing asset and buying an investment with lower returns may seem counterintuitive, but the objective of rebalancing is to manage risk rather than maximize return.

When investors select an asset allocation, they choose a mix of assets that is expected to produce returns that can help them meet their goals with a level of risk they can tolerate. By periodically rebalancing, investors can diminish the tendency for portfolios to drift to a risk level that is inconsistent with their risk profile.

Rebalancing can also help with discipline and emotional control when markets are volatile. A set policy will trigger rebalancing events in a consistent manner no matter which direction markets head, which means investors are less likely to make any rash decisions to buy or sell securities that may jeopardise their long-term investment goals.

7 min read
The Basics
Building a well-diversified investment portfolio may seem out of reach. ETFs could be a good way to kick-start your savings and investment plan.

Learn more

5 min read
Once you have decided you are ready to invest, your next question might be whether to invest in an exchange-traded fund or an unlisted managed fund.

Learn more

6 min read
Investment Strategy
If deciding which asset classes to include in your portfolio seems overwhelming, consider investing in a diversified fund or ETF.

Learn more

Join more than 50,000 fellow investors to learn about investment and personal finance in our free weekly Smart Investing™ newsletter.