The concept of rebalancing is an essential practice in managing investment portfolios. Rebalancing involves periodically adjusting the asset allocation of a portfolio to bring it back to its original or desired target allocation. It involves buying or selling assets within the portfolio to maintain the desired balance between different asset classes.
The reason behind rebalancing is that over time, the value of different asset classes within a portfolio can change at different rates, causing the portfolio’s asset allocation to deviate from the intended allocation. This deviation can lead to unintended risks or expose the portfolio to higher volatility.
Here’s how the process of rebalancing typically works:
- Establishing a target allocation: Initially, when constructing a portfolio, an investor determines the target allocation based on their investment objectives, risk tolerance, and time horizon. This target allocation specifies the desired percentage of each asset class in the portfolio, such as stocks, bonds, cash, or alternative investments.
- Monitoring portfolio performance: Regular monitoring of the portfolio is essential to identify any significant deviations from the target allocation. This monitoring can be done monthly, quarterly, or annually, depending on the investor’s preferences and market conditions.
- Identifying deviations: When monitoring the portfolio, if the actual allocation of a particular asset class deviates significantly from the target allocation, it may be time to consider rebalancing. For example, if stocks have outperformed bonds, the equity allocation in the portfolio may have increased beyond the desired level.
- Determining rebalancing strategy: There are different approaches to rebalancing. The two main strategies are time-based and threshold-based.
- Time-based rebalancing: With this approach, the investor rebalances the portfolio at regular intervals, such as every quarter or annually, regardless of the extent of deviation from the target allocation. This strategy ensures discipline and prevents emotional decision-making.
- Threshold-based rebalancing: In this approach, the investor sets specific thresholds or tolerance bands for each asset class. If an asset class deviates beyond the predetermined threshold, the portfolio is rebalanced to bring it back within the acceptable range. For example, if the target allocation for stocks is 60%, and the threshold is set at 5%, rebalancing would be triggered if the stock allocation exceeds 65% or falls below 55%.
- Execution of rebalancing: Once the decision to rebalance is made, the investor implements the changes by buying or selling assets. This process involves selling a portion of the overweighted asset class and using the proceeds to purchase the underweighted asset class.
- Considerations during rebalancing: While rebalancing, investors should also consider transaction costs, tax implications, and liquidity needs. They may need to prioritize certain assets or use alternative methods like cash flows or new contributions to rebalance the portfolio.
By regularly rebalancing the portfolio, investors aim to maintain their desired risk profile and prevent their portfolios from becoming too concentrated in a particular asset class. Rebalancing essentially ensures that the portfolio stays aligned with the investor’s long-term goals, risk tolerance, and investment strategy.
