Portfolio Rebalancing Like Balancing a Tire

from Make Your Money Count by Jim Munchbach

Portfolio Rebalancing is dynamic asset allocation. With this strategy, you constantly adjust the mix of assets as markets rise and fall, and as the economy strengthens and weakens. With this strategy, you sell assets that decline and purchase assets that increase.

The metaphor I use to explain Portfolio Rebalancing is balancing a tire. When I was a mechanic, and a customer came to my shop because the car was shaking, the problem was almost always that a tire was out of balance, sometimes caused by a small bump of rubber from uneven wear. Even a seemingly small imbalance of a quarter of an ounce could cause the tire to shake violently at high speeds. I applied a weight to counterbalance the wheel.

We checked it on the balancing machine to be sure it ran smoothly, put it back on the car, and the customer was ready to go.

Portfolio Rebalancing RE-balances the portfolio, so the assets run smoothly toward your goals. Sometimes people only need to make small adjustments, but often they need to make major changes in the distribution of assets. Some people are so risk-averse that they want to keep all their money in cash, and they want to divide it up so they stay under the FDIC limits in each institution. But this strategy only limits risk in the immediate future. Returns on cash accounts don’t even keep pace with inflation, so there is no opportunity for asset appreciation and they actually increase their long-term risk.

Like Balancing a Tire

Portfolio Rebalancing

Explained by James Chen at Investopedia

Rebalancing is the process of realigning the weightings of a of assets. Rebalancing involves periodically buying or selling to maintain an original or desired or risk.

For example, say an original target was 50% stocks and 50% bonds. If the stocks performed well during the period, it could have increased the stock weighting of the portfolio to 70%. The investor may then decide to sell some stocks and buy bonds to get the portfolio back to the original target allocation of 50/50.

Primarily, portfolio rebalancing safeguards the investor from being overly exposed to undesirable risks. Secondly, rebalancing ensures that the portfolio exposures remain within the manager’s area of expertise.

Often, these steps are taken to ensure the amount of risk involved is at the investor’s desired level. As stock performance can vary more dramatically than bonds, the percentage of assets associated with stocks will change with market conditions. Along with the performance variable, investors may adjust the overall risk within their portfolios to meet changing financial needs.

“Rebalancing,” as a term, has connotations regarding an even distribution of assets; however, a 50/50 stock and bond split is not required. Instead, rebalancing a portfolio involves the reallocation of assets to a defined makeup. This applies whether the target allocation is 50/50, 70/30 or 40/60.

While there is no required schedule for rebalancing a portfolio, most recommendations are to examine allocations at least once a year. It is possible to go without rebalancing a portfolio, though this would generally be ill-advised. Rebalancing gives investors the opportunity to sell high and buy low, taking the gains from high-performing investments and reinvesting them in areas that have not yet experienced such notable growth.

Calendar rebalancing is the most rudimentary rebalancing approach. This strategy simply involves analyzing the investment holdings within the portfolio at predetermined time intervals and adjusting to the original allocation at a desired frequency. Monthly and quarterly assessments are typically preferred because weekly rebalancing would be overly expensive while a yearly approach would allow for too much intermediate portfolio drift.

The ideal frequency of rebalancing must be determined based on time constraints, transaction costs and allowable drift. A major advantage of calendar rebalancing over more responsive methods is that it is significantly less time consuming and costly for the investor since it involves less trades and at pre-determined dates. The downside, however, is that it does not allow for rebalancing at other dates even if the market moves significantly.

A more responsive approach to rebalancing focuses on the allowable percentage composition of an asset in a portfolio – this is known as a constant-mix strategy with bands or corridors. Every asset class, or individual security, is given a target weight and a corresponding tolerance range.

For example, an allocation strategy might include the requirement to hold 30% in emerging market equities, 30% in domestic blue chips and 40% in government bonds with a corridor of +/- 5% for each asset class. Basically, emerging market and domestic blue chip holdings can both fluctuate between 25% and 35%, while 35% to 45% of the portfolio must be allocated to government bonds.

When the weight of any one holding moves outside of the allowable band, the entire portfolio is rebalanced to reflect the initial target composition.

The most intensive rebalancing strategy commonly used is constant proportion portfolio insurance (CPPI) is a type of portfolio insurance in which the investor sets a floor on the dollar value of their portfolio, then structures asset allocation around that decision.

The asset classes in CPPI are stylized as a risky asset (usually equities or mutual funds) and a conservative asset of either cash, equivalents, or treasury bonds. The percentage allocated to each depends on a”cushion” value, defined as the current portfolio value minus some floor value, and a multiplier coefficient.

The greater the multiplier number, the more aggressive the rebalancing strategy. The outcome of the CPPI strategy is somewhat similar to that of buying a synthetic call option that does not use actual option contracts. CPPI is sometimes referred to as a convex strategy, as opposed to a “concave strategy” like constant-mix.

Key Takeaways

• Rebalancing is the act of adjusting portfolio asset weights in order to restore target allocations or risk levels over time.

• There are several strategies for rebalancing such as calendar-based, corridor-based, or portfolio-insurance based.

• Calendar rebelancing is the least costly but is not responsive to market fluctuations, meanwhile a constant mix strategy is responsive but more costly to put to use.

Rebalancing Retirement Accounts

One of the most common areas investors look to rebalance are the allocations within their retirement accounts. Asset performance impacts the overall value, and many investors prefer to invest more aggressively at younger ages and more conservatively as they approach retirement age. Often, the portfolio is at its most conservative once the investor prepares to draw out the funds to supply retirement income.

Rebalancing for Diversification

Depending on market performance, investors may find a large number of current assets held within one area. For example, should the value of stock X increase by 25% while stock Y only gained 5%, a large amount of the value in the portfolio is tied to stock X. Should stock X experience a sudden downturn, the portfolio will suffer higher losses by association. Rebalancing lets the investor redirect some of the funds currently held in stock X to another investment, be that more of stock Y or purchasing a new stock entirely. By having funds spread out across multiple stocks, a downturn in one will be partially offset by the activities of the others, which can provide a level of portfolio stability.

The Art of Portfolio Rebalancing

Maintaining Balance for Long-Term Investment Success

Table of Contents:

I. Introduction to Portfolio Rebalancing

II. Understanding Portfolio Rebalancing

III. Why Portfolio Rebalancing is Important

IV. Strategies for Portfolio Rebalancing

A. Time-based Rebalancing

B. Threshold-based Rebalancing

C. Constant-Weighting Rebalancing

V. Tips for Successful Portfolio Rebalancing

VI. Conclusion

Introduction to Portfolio Rebalancing

Portfolio rebalancing is a critical process that investors should undertake regularly to maintain a balanced portfolio that aligns with their investment goals and risk tolerance. The process involves adjusting the allocation of assets in a portfolio to ensure that it remains in line with the investor’s investment objectives, risk tolerance, and market conditions.

Understanding Portfolio Rebalancing

Portfolio rebalancing involves selling and buying assets in a portfolio to maintain the desired allocation of assets. As asset values rise and fall, the percentage of assets allocated to each investment will change, which may lead to a portfolio becoming unbalanced. Rebalancing seeks to rectify this by selling some investments and buying others to bring the portfolio back in line with the desired asset allocation.

Why Portfolio Rebalancing is Important

Portfolio rebalancing is essential for long-term investment success because it helps investors maintain a balanced portfolio, reducing the risk of losses during market fluctuations. It also enables investors to lock in gains by selling assets that have performed well and investing in underperforming assets that may provide higher returns in the future.

Strategies for Portfolio Rebalancing

There are several strategies that investors can use to rebalance their portfolios, including time-based rebalancing, threshold-based rebalancing, and constant-weighting rebalancing.

A. Time-based Rebalancing

Time-based rebalancing involves rebalancing a portfolio at set intervals, such as every quarter, year, or two years. This strategy is straightforward and easy to follow, but it may not be ideal for all investors as it ignores changes in market conditions.

B. Threshold-based Rebalancing

Threshold-based rebalancing involves rebalancing a portfolio when the allocation of assets deviates from the target allocation by a certain percentage. This strategy allows for more flexibility in rebalancing and is useful for investors who want to take advantage of market fluctuations.

C. Constant-Weighting Rebalancing

Constant-weighting rebalancing involves rebalancing a portfolio to maintain a constant allocation of assets. This strategy is suitable for investors who want to maintain a consistent risk profile and do not want to deviate from their target asset allocation.

Tips for Successful Portfolio Rebalancing

Successful portfolio rebalancing requires discipline, patience, and a clear understanding of one’s investment goals and risk tolerance. Here are some tips for successful portfolio rebalancing:

• Determine your investment goals and risk tolerance before deciding on a rebalancing strategy.

• Regularly review your portfolio to ensure it aligns with your investment objectives.

• Use a rebalancing strategy that works best for you.

• Be patient and avoid making impulsive decisions based on short-term market fluctuations.

Conclusion

Portfolio rebalancing is an essential process that investors should undertake regularly to maintain a balanced portfolio that aligns with their investment goals and risk tolerance. By using the right rebalancing strategy and being disciplined and patient, investors can achieve long-term investment success and reduce the risk of losses during market fluctuations.