What Is Rebalancing?
Rebalancing is the process of adjusting the values of a portfolio’s asset allocations to match the levels defined by an investment plan. These levels are meant to align with an investor’s risk tolerance and desired rewards.
Over time, market performance can alter asset values, causing shifts in asset allocations. Rebalancing involves periodically buying or selling portfolio assets to restore the original, desired allocation levels.
For example, consider a portfolio with an original target allocation of 50% stocks and 50% bonds. If stock prices rise, their increased value could inflate their proportion in the portfolio to 70%. The investor might then sell some stocks and buy bonds to realign the portfolio back to the 50%-50% target allocation.
Key Takeaways
- Rebalancing involves adjusting a portfolio’s asset allocation to match the original plan defined by an investor’s risk and reward profile.
- Various strategies for rebalancing exist, such as calendar, constant-mix, and portfolio-insurance.
- Calendar rebalancing is inexpensive but may not respond to market fluctuations.
- Constant-mix strategy is responsive yet more costly compared to calendar rebalancing.
- Rebalancing costs include transaction fees and potential exposure to higher risks.
Understanding How Rebalancing Works
Portfolio rebalancing aims to prevent unwanted risks while ensuring exposure to potential rewards. It also keeps the portfolio within the manager’s expertise area.
Sometimes, stock prices fluctuate more dramatically than bonds, warranting the need to assess the portfolio’s equity proportion. If equity value increases beyond the target percentage, rebalancing is necessary by selling some stocks to lower the equity percentage.
Investors can also adjust portfolio risk to meet evolving financial needs. For instance, increasing equity exposure to boost returns or focusing on bonds for more stable income.
It’s crucial to understand that rebalancing doesn’t mean an even asset split. Target allocation varies depending on the investor’s goals and needs and could be 70% stocks and 30% bonds, 10% cash, 40% stocks, and 50% bonds, etc.
When to Rebalance
While no strict schedule for rebalancing exists, examining allocations at least once a year is advisable. Rebalancing lets investors sell high-performing investments and reinvest in areas with potential future growth.
An investment plan, which outlines asset allocations and rebalancing processes, ensures that investors stick to their strategies and avoid detrimental actions.
Types of Rebalancing
Calendar Rebalancing
Calendar rebalancing analyzes and adjusts portfolio holdings at predetermined intervals. Long-term investors often rebalance annually, while others may do so quarterly or monthly. Weekly rebalancing might be unnecessarily expensive and time-consuming.
This method is less costly but not inherently responsive to market changes.
Constant-Mix Rebalancing
Constant-mix rebalancing focuses on maintaining asset weights within predetermined bands. Each asset class or security is assigned a target weight and tolerance range. For example, holding 30% in emerging market equities, 30% in domestic blue chips, and 40% in government bonds with a 5% band. Exceeding these bands triggers a portfolio-wide adjustment.
Constant Proportion Portfolio Insurance (CPPI)
CPPI is a sophisticated strategy setting a floor on the portfolio’s value. Asset allocations fluctuate based on a “cushion value” and a multiplier, with higher multipliers indicating more aggressive strategies. CPPI mimics the effects of synthetic call options, providing a layer of protection on investments.
Smart Beta Rebalancing
Smart beta rebalancing periodically adjusts based on performance measures like book value or return on capital. This systematic approach counters market inefficiencies in simple index investing and avoids emotional decision-making.
Examples of Rebalancing
Rebalancing Retirement Accounts
A common rebalancing scenario involves retirement accounts. Younger investors may prefer aggressive investments and gradually shift towards safer allocations as retirement nears, ultimately leading to a larger allocation in fixed income securities as they prepare to draw on these funds.
Rebalancing for Diversification
Market performance changes can cause asset concentration in certain investments. For instance, if stock X’s value rises significantly compared to stock Y, a downturn in stock X could severely impact the portfolio. Rebalancing diversifies investments, spreading risk and stabilizing the portfolio.
Advantages and Disadvantages of Rebalancing
Advantages
- Keeps portfolios aligned with risk tolerance and desired returns.
- Adheres to a disciplined investment approach.
- Adjustable as financial needs and goals evolve.
- Mannable by experienced individual investors or portfolio managers.
Disadvantages
- Involves transaction costs reducing net income.
- Might miss out on potential gains from high-performing assets.
- Requires investment knowledge to rebalance effectively.
- Unnecessary rebalancing increases costs.
What Does Rebalancing a Portfolio Mean?
Rebalancing involves selling and buying to bring each portfolio allocation to the levels established by an investment plan.
Does Rebalancing Have Costs?
Yes, rebalancing includes transaction fees and costs related to performance disruptions. Selling high-value securities could prevent benefiting from continuous price increases. Committing to an investment plan helps prepare for these costs in advance.
How Often Should I Rebalance?
Rebalancing frequency depends on investment goals, risk tolerance, and financial needs. Long-term, “buy and hold” investors might rebalance yearly, while those with short-term goals should rebalance more frequently to stay agile in achieving their objectives.
Related Terms: Asset Allocation, Investment Plan, Portfolio Management, Risk Tolerance, Market Performance.
