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3 Essential Factors for Effective Index Fund Rebalancing


Index funds have become incredibly popular among investors in recent years. Some estimates suggest that the growth of exchange-traded funds (ETFs) could top 13% this year. This growth is driven by the increasing popularity of passive investing which allows investors to take a largely “buy and hold” attitude to investing.
While the simplicity of passive investing is nice, it doesn’t mean that investors should simply sit back and forget about their investments. Daily portfolio monitoring is not needed with passive investing but investors do need to be aware of what is happening with the economy and the markets to ensure that their investments are going to meet their needs.
In this article, we will discuss index fund rebalancing and how passive investors can use this strategy to get better returns and potentially reduce risk as the market goes through its natural cycles.

Why Index Fund Rebalancing is Important

Investment goals, life goals, and the investment landscape can change significantly as time passes. In order to maximize growth, minimize losses, and ensure that your risk tolerance matches the risk profile of your portfolio, regular index fund rebalancing must be done. As you go through the different stages of life, rebalancing your portfolio should be done so that your portfolio risk becomes lower as you get closer to retirement. However, many passive investors overlook the need for rebalancing during the various stages of the economic cycle.

The economic cycle includes the four stages: expansion, peak, contraction, and trough. The expansion stage represents economic growth, the peak stage is the height of the economic growth, the contraction stage indicates a recession may be underway, and the trough is the lowest point of the economic cycle.

Index fund rebalancing that is specifically targeted at different phases of the economic cycle is an important part of any investment review process. Here are some of the factors you should consider when rebalancing and how each plays a greater role during different phases of the economic cycle.

1. Look for Value When Times are Tough

Value investing is a popular style of investing regardless of how the economy is doing. Some investors are always seeking companies that they feel are undervalued compared to their true value. During economic recovery, value investing is an especially good strategy to follow. As the economic cycle moves from trough to expansion, it is expected that stock prices will rise. This is an opportunity to find index funds that track industries which should see greater growth as the economy improves and consumers begin spending more money.

Using this strategy, investors may achieve growth as the economy moves upward from its lowest point. In the past, technology indexes and consumer discretionary indexes have been very popular value investments during the trough and expansion phases. It’s always nice to have value investments in your portfolio, but you may wish to balance your portfolio to focus more heavily on value industries at this point in the economic cycle. As the economy continues to move into different cycles, you may wish to hold onto some value investments but reduce your overall exposure.

2. Use Momentum to Continue Growth

After the markets leave the trough stage of the economic cycle, the next stage is expansion. Investors and consumers are more positive about the economy and index prices are rising. Some industries will inevitably grow at a faster pace than other industries. During the expansion phase, it is often a good idea to ride the momentum of rapidly growing index funds. As the market continues to grow, momentum can be a powerful factor that may allow you to realize growth.

There is also a psychological aspect to this index fund rebalancing strategy. As markets heat up, people want to invest more of their money. People who may not be regular investors may be looking to buy stocks or indexes. This bandwagon effect can cause prices to rise even faster. When investing, having momentum on your side is a nice thing.

3. Look for Quality at the Peak

Identifying when the market has reached its peak is not always easy. As they say, time in the market beats timing the market. Slowing growth may indicate that the expansion phase of the economic cycle has come to an end. This is no time to panic as, although growth has slowed, it may be a long time until any sort of downturn occurs. During the peak phase of the economic cycle, quality investments are what you want to be looking for. These are established industries that typically remain steady throughout all stages of the economic cycle. That’s not to say these industries won’t experience growth and losses, but those swings will be much less pronounced than more volatile industries.

Some examples of these industries could include pharmaceuticals, healthcare, and financials. Essentially, any industry that people need regardless of how well the economy is doing is an industry that should perform well as market growth slows. When the economy begins to contract, these industries should feel less shock and help minimize losses.

These quality industries are also a great way to reduce risk in your portfolio. If you are chasing value or momentum as the economy grows, stable industries can be a nice counterbalance that provides stability to a portfolio heavily focused on growth. Later in life, these quality industries will make up a greater portion of your portfolio as you take less and less risk once retirement draws near.

Don’t Stress Over Rebalancing

When the topic of index fund rebalancing comes up, some passive investors may feel like this flies in the face of their “buy and hold” mentality. Rebalancing does not have to be a frequent activity that requires a lot of time and research effort. Rather, index fund rebalancing could be done quarterly or even less frequently depending on your investment goals and stage of life.

Staying true to your passive investment philosophy can be done with regular portfolio rebalancing. Take some time to consider how your portfolio is balanced, what stage of life you are in, and what stage the economic cycle is in. Rebalancing according to those factors may help you make the most of growth in the markets and may minimize losses when the market is experiencing contraction. At Linden Thomas and Company, we help investors build the plan that is right for them and their families. We can guide you through the process with expert advice recognized by the top publications in America.

Make the most of your investments and build a stronger financial future. Contact us at Linden Thomas and Company today.

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