Portfolio rebalancing refers to the process of adjusting portfolio weights back to the ones defined by the original and desired investment plan. Asset weights will stray from the original allocation due to market volatility and price changes. For example, if you have a defined balanced risk profile (50/50) which has a portfolio that has shifted to 80% equity, 20% fixed income, rebalancing would involve increasing exposure to fixed income and decreasing exposure to equities.
Rebalancing becomes especially important during bull markets, when the equity risk in a portfolio grows alongside stock appreciation. Often this heightened level of risk can exceeds the a person’s risk tolerance. Sticking to your investment goals and strategy, therefore, require buying and selling assets to regaining the desired weighting.
Rebalancing is an important element of portfolio management because it ensures that the portfolio’s risk is always within your risk tolerance and that the probability of achieving your investment goals is always maximized Another advantage of periodic rebalancing is that it establishes an automatic process where you are forced to buy low and sell high.
Corridor rebalancing, meanwhile, involves keeping track of the portfolio’s asset weights at all times. When the asset weights deviate from the target allocation by a certain amount or exceed the tolerance range, rebalancing is initiated to restore the target allocation. The level of deviation that triggers dynamic rebalancing is typically 5 to 15 percentage points.
The wider the range of allowable deviation, the fewer times rebalancing is required. It’s worth noting, however, that this type of rebalancing becomes more frequent when the market becomes more volatile, and assets drift in and out of their corridors. Numerous considerations come into play when determining the type and frequency of rebalancing. First, there’s transaction cost. For corridor rebalancing, higher transactional costs can be mitigated by setting wider corridors. For instance, a higher transaction cost may incur when the underlying asset is illiquid. The goal is to find a smart balance between controlling rebalancing frequency and trading costs so that the value of rebalancing can be optimized.
Another important consideration is risk tolerance. Investors with high-risk aversion should try to rebalance more frequently (by setting tighter corridors or shorter calendar periods) in order to ensure the asset allocation is always in line with the client’s risk profile.
There’s also correlation to take into account. When asset classes correlate, less rebalancing is required because the equity and fixed income portions rise and fall simultaneously, thereby maintaining their desired weightings. For instance, an investor who holds stocks and bonds in the same corporation would see these values rise and fall simultaneously on corporate news. In this case, a lack of diversification (and higher risk) results in less need to rebalance.
A more diversified, less correlated portfolio, meanwhile, requires more rebalancing because the asset-class weighting would tend to drift more significantly. Finally, the frequency of rebalancing can also be affected by your judgment. If you believe that the current trend will not change (momentum), then a wider rebalancing range is used to avoid missing out on an upward price trend. If you believe that the trend will reverse, leading values to revert to an average, this requires more frequent rebalancing. More rebalancing is also recommended in volatile markets, in order to control risk. Overall, how often to rebalance is a complicated question that depends on investment goals, risk tolerance and market conditions.
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When equities fall into underpriced territory, rebalancing calls for you to buy; when you rise into overpriced territory, rebalancing demands you to sell. This is hard to achieve without rebalancing because it runs contrary to the natural greed- and fear-driven tendencies to buy when markets are booming and sell when markets are crashing.
A rebalancing strategy that sells an asset that is overweighted and buys an underweighted asset is more likely to achieve the goal of buying low and selling high. The lack of periodic rebalancing eventually leads to portfolios that are concentrated in top performers — which can become increasingly risky as they appreciate — while defensive assets that are used to protect against risk become gradually diluted and marginalized. These kinds of portfolios become particularly vulnerable if markets correct because defensive assets lack the weighting needed to diversify against the rapid devaluation of growth assets.
Portfolio rebalancing can be achieved by periodic (calendar) rebalancing and percentage-range (corridor) rebalancing. Calendar rebalancing involves buying and selling at certain time intervals. This interval can be yearly, quarterly or monthly. However, transaction costs will increase as the rebalancing frequency increases. The ideal rebalancing frequency should be determined by investment horizon, allowance for value drift and transaction costs.
Frequently Asked Questions
Q: What is rebalancing?
A: Rebalancing involves selling and buying assets to bring portfolio weightings back into alignment with the original and desired investment plan.
Q: Why is rebalancing important?
A: Rebalancing ensures your portfolio is aligned with your risk tolerance and investment plan. It reduces portfolio risk by avoiding concentrated positions in the portfolio. Rebalancing can also impose a discipline on you that reduces emotional or unnecessary trading and compels you to act against the irrational tendency to buy at market highs and sell at market lows.
Q: How do you rebalance a portfolio?
A: You can rebalance your portfolio periodically (monthly, quarterly, yearly) or by setting “corridors” in which allocation weightings may deviate (5, 10, 15 percentage points). Periodic rebalancing is less reactive than corridor rebalancing, which may be undesirable depending on the your risk profile. Corridor rebalancing is more reactive to market movements, but may result in more transactional costs in a volatile market.
Q: What are some of the considerations that an investor must take into account when determining the type and frequency of rebalancing required?
A: Transaction cost: Shorter periods and narrow corridors of deviation result in more transactions and therefore higher costs.