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.
Like Balancing a Tire
Asset Allocation
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
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Rebalancing is the act of adjusting portfolio asset weights in order to restore target allocations or risk levels over time.
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There are several strategies for rebalancing such as calendar-based, corridor-based, or portfolio-insurance based.
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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
