A cheat sheet to portfolio rebalancing

Perfectly Balanced: Portfolio Rebalancing

'Perfectly balanced, just like everything should be’ are the words of a man with less than admirable plans, but they are very true, especially in the case of portfolios.

Selecting and establishing an asset allocation strategy is one thing, sticking to one and maintaining a portfolio that is in harmony with it is another. With time, your portfolio is bound to deviate from your initial plan. Portfolio rebalancing is just what you need in such a scenario.

What is Portfolio Rebalancing?

Portfolio rebalancing refers to the process of buying and selling securities to return to the predetermined asset allocation as per the investment strategy.

Rebalancing needs to be done periodically because, over time, the value of assets and their volatility change, and a lot of assets are bought and sold as well. This takes the portfolio away from the original allocation and could expose you to more risk than you desire. Additionally, your risk tolerance and investment goals can change over time, and rebalancing helps adjust to these changes.

How Rebalancing Works

Portfolio rebalancing is a strategy where investors adjust the mix of assets in their portfolio to maintain a desired allocation over time. For instance, if stocks perform well and their proportion increases beyond the desired level, investors may sell some stocks and buy other assets like bonds to restore balance.

This strategy helps manage risk by preventing the portfolio from becoming too heavily weighted in any single asset class. For example, let's say an investor's target allocation is 60% stocks and 40% bonds. If stocks outperform and their share grows to 70%, the investor might sell some stocks and reinvest the proceeds into bonds to realign the allocation to 60/40.

This proactive approach not only helps to mitigate risk but also allows investors to capitalize on market fluctuations, potentially enhancing returns over time.

Importance of Portfolio Rebalancing

Portfolio rebalancing is an essential element of risk management. It allows you to avoid being concentrated on highly risky assets and being overexposed to risks. Rebalancing allows you to diversify your portfolio to match it with your risk appetite.

With time, the asset mix of a portfolio changes. As you buy and sell assets, the asset allocation is bound to deviate from your original plan. Portfolio rebalancing gives you an idea of how far you are from your initial plan and lets you avoid any deviation from it.

Over time, not only do market conditions change but so do your risk tolerance and investment goals. You might need a new strategy that suits your needs better. Portfolio rebalancing allows you to smoothly make changes to your portfolio that align with a revised investment strategy.

You adjust the weights of different assets in your portfolio through rebalancing; this allows you to identify assets that have yielded good returns. Investors can identify and benefit from market trends by purchasing assets that fell in value and selling the ones that have risen.

Pros

• Objective and unemotional approach, reducing exposure to risks.
• Brings portfolios back in line with the original plan.
• Allows flexibility to align with a new investment strategy.
• Accessible for portfolio managers or small investors.
• Keeps the asset mix aligned with risk tolerance and expected return.

Cons

• May require selling assets that have appreciated, potentially missing further gains.
• High number of transactions, leading to increased costs.
• Requires market knowledge, challenging for beginner traders.

Methods of Rebalancing

Calendar Rebalancing

The most basic method of rebalancing is calendar rebalancing. With this approach, investors simply review their investment portfolio at set intervals and adjust it to match the original allocation according to a chosen frequency.

• Monthly or quarterly assessments are commonly favored.
• Determining the optimal rebalancing frequency depends on factors such as time constraints, transaction fees, and acceptable levels of drift.
• Calendar rebalancing requires less time compared to formulaic rebalancing.

Constant Proportion Portfolio Insurance (CPPI)

CPPI requires the investor to set a base or floor value to the per buck value of their portfolio.

• Assumes risk tolerance increases with wealth.
• Investors hold a minimum reserve in risk-free securities and allocate the rest based on risk appetite.
• Adjusts allocations as portfolio value rises or falls.
• Often referred to as a convex strategy, similar to a synthetic call option.

Striking a Balance

Portfolio rebalancing is a critical tool for effective investment management, offering both advantages and disadvantages that investors must carefully consider. It helps investors mitigate risks, maintain discipline, and adapt to changing market conditions.

While portfolio rebalancing offers numerous benefits, it also presents challenges, particularly in terms of cost and complexity. Selling appreciated assets may result in missed opportunities for further gains, while frequent transactions can incur higher transaction costs and tax implications.

In essence, portfolio rebalancing is a fundamental aspect of prudent investment management, enabling investors to navigate market fluctuations, manage risk, and pursue long-term financial goals with confidence.

When to Rebalance a Portfolio?

The frequency or time of portfolio rebalancing is decided on the basis of triggers. The three most common triggers are:

• Threshold: Rebalance when the portfolio deviates from the decided asset allocation by a certain percentage.
• Time: Rebalance at decided intervals, e.g., every 6 months or a year.
• Threshold and Time: Combines time and threshold triggers for more nuanced adjustments.

Conclusion

Rebalancing a portfolio helps mitigate risks, uphold discipline, and adapt to market dynamics. It maintains alignment with investment strategies and risk tolerance. However, rebalancing poses challenges like high transaction costs and tax implications. Investors can strike a balance between risk management and opportunity optimization by judiciously weighing these factors and employing appropriate rebalancing methods.

Portfolio rebalancing empowers investors to navigate market uncertainties with confidence, ensuring their portfolios remain resilient and aligned with long-term financial objectives.