Rebalancing

What Is Rebalancing?

Rebalancing refers to the process of returning the values of a portfolio's asset allocations to the levels defined by an investment plan. Those levels are intended to match an investor's tolerance for risk and desire for reward.

Over time, asset allocations can change as market performance alters the values of the assets. Rebalancing involves periodically buying or selling the assets in a portfolio to regain and maintain that original, desired level of asset allocation.

Take a portfolio with an original target asset allocation of 50% stocks and 50% bonds. If the stocks' prices rose during a certain period of time, their higher value could increase their allocation proportion within the portfolio to, say, 70%. The investor may then decide to sell some stocks and buy bonds to realign the percentages back to the original target allocation of 50%-50%.

Key Takeaways

  • Rebalancing is the act of adjusting a portfolio's changed asset allocation to match an original allocation defined by an investor's risk and reward profile.
  • There are several types of strategies for rebalancing, such as calendar, constant-mix, and portfolio-insurance.
  • Calendar rebalancing is the least costly but is not responsive to market fluctuations.
  • The constant-mix strategy is responsive but more costly to use than calendar rebalancing.
  • Costs of rebalancing can include transaction fees, inadvertent exposure to higher risk, and selling assets as they are increasing in value.

How Rebalancing Works

Portfolio rebalancing aims to protect investors from exposure to undesirable risks while providing exposure to reward. It can also ensure that a portfolio's exposure remains within the portfolio manager's area of expertise.

There are times when a stock's price performance can vary more dramatically than that of bonds. Therefore, a portfolio's percentage of equity-related assets should be assessed as market conditions change. If the value of equities in a portfolio causes the allocation in stocks to rise above their preset percentage, a rebalancing may be in order. That would involve selling some shares of stock to lower the overall percentage of equities in the portfolio.

Investors may also wish to adjust their overall portfolio risk to meet changing financial needs. For instance, an investor who needs a greater potential for return might increase the allocation in assets that involve higher risk, such as equities, to improve that potential. Or, if income becomes more important than it was before, the allocation of bonds could be increased.

Some investors may mistakenly understand rebalancing to refer to adjusting for an even distribution of assets. However, a 50%-50% stock and bond split is not required. A portfolio's target allocation of assets just as easily could be 70% stocks and 30% bonds, 40% stocks and 60% bonds, or 10% cash, 40% stocks, and 50% bonds. The allocation depends on the goals and needs of an investor.

When to Rebalance

While there is no required schedule for rebalancing a portfolio, it's recommended that investors examine allocations at least once every year. Investors don't have to rebalance but generally, that's 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 are expected to see notable growth.

An investment plan—where asset allocations and rebalancing are defined—can range from a simple idea or strategy created by an individual to a multi-page package developed by a portfolio manager. An investment plan can help ensure that every investor takes needed actions, including rebalancing, and avoids inappropriate steps that could affect a portfolio's return negatively.

Types of Rebalancing

Calendar Rebalancing

Calendar rebalancing is the most rudimentary rebalancing approach. This strategy involves analyzing and adjusting the investment holdings within the portfolio at predetermined times.

Many long-term investors rebalance once a year. Other types of investors with different outlooks and goals may rebalance quarterly, or even monthly. Weekly rebalancing could be overly expensive and unnecessary.

The ideal frequency of rebalancing must be determined based on an investor's time constraints, threshold for transaction costs, and allowance for value drift. Advantages of calendar rebalancing over more responsive methods are that it is less time consuming and costly for the investor since it involves fewer rebalancing occasions and potentially fewer trades. However, a downside is that it does not call for rebalancing at other dates even if the market moves significantly.

Constant-Mix Rebalancing

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.

Therefore, emerging market and domestic blue chip holdings can both fluctuate between 25% and 35%. At the same time, 35% to 45% of the portfolio must be allocated to government bonds. When the weight of any one holding moves outside of its allowable band, the entire portfolio is rebalanced to reflect the initial target composition.

Constant Proportion Portfolio Insurance

The most intensive rebalancing strategy commonly used is constant proportion portfolio insurance (CPPI) is a type of portfolio insurance that allows the investor to set a floor on the dollar value of their portfolio and structure the asset allocation on it.

The asset classes in CPPI are styled as a risky asset, such as equities or mutual funds, and a conservative asset of either cash, 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.

Smart Beta Rebalancing

Smart beta rebalancing is a periodic rebalancing similar to the regular rebalancing that indexes undergo to adjust to changes in stock value and market capitalization.

Smart beta strategies take a rules-based approach to avoid the market inefficiencies that creep into index investing due to the reliance on market capitalization. Smart beta rebalancing uses additional criteria, such as value as defined by performance measures like book value or return on capital, to allocate the holdings across a selection of stocks.

This rules-based method of portfolio creation adds a layer of systematic analysis to the investment that simple index investing lacks. 

Although smart beta rebalancing is more active than simply using index investing to mimic the overall market, it is less active than stock picking. One of the key features of smart beta rebalancing is that emotions are taken out of the process.

Depending on how the rules are set up, an investor may end up trimming exposure to their top performers and increasing exposure to less stellar performers. This runs counter to the old adage of letting your winners run, but the periodic rebalancing realizes the profits regularly rather than trying to time market sentiment for maximum profit.

Smart beta can also be used to rebalance across asset classes if the proper parameters are set. In this case, the risk-weighted returns are often used to compare different types of investments and adjust exposure accordingly.  

Examples of Rebalancing

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. So, over the years, a portfolio may be rebalanced to reflect an increasingly greater allocation in fixed income securities.

Rebalancing for Diversification

Depending on market performance, investors may find a large number of 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.

Advantages and Disadvantages of Rebalancing

Advantages

  • Rebalancing can keep investors' portfolios aligned with their risk tolerance and need for a certain amount of return.
  • It maintains a pre-determined asset allocation set by an investment plan.
  • It's a disciplined, unemotional investment approach that can reduce exposure to risk.
  • It can be changed as investors' financial needs and investment goals change.
  • Rebalancing can be done by experienced individual investors or handled by portfolio managers.

Disadvantages

  • Rebalancing involves transaction costs, which may reduce net income.
  • Selling securities that have increased in value to rebalance a portfolio might lead to investors missing out on an upward price trend of those securities.
  • Investing knowledge and experience is required to rebalance as needed and reduce exposure to risk appropriately.
  • Unnecessary rebalancing can increase costs for an investor.

What Does Rebalancing a Portfolio Mean?

It means selling and buying the necessary securities to bring the value of each allocation in a portfolio back to the level established by an investment plan.

Does Rebalancing Have Costs?

Yes, it does. It involves the fees related to the transactions to purchase and sell securities. It can also involve the cost of performance. For example, to rebalance, you might sell securities that have increased in value and pushed your allocations out of whack. However, you could miss out on a continued upswing in prices that those securities experience. By making rebalancing part of an investment plan that you commit to, you'll be aware of (and can accept) these and other potential costs in advance.

How Often Should I Rebalance?

That depends on your investment goals, risk tolerance, and financial needs. For example, long-term investors who take a buy and hold approach to the markets might consider reviewing their allocations once a year with their financial advisors to see if rebalancing is warranted. Other investors with shorter-term goals may wish to rebalance more frequently to be sure they stay on track to meet those goals.

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