Portfolio rebalancing is the periodic adjustment of asset allocation in an investment portfolio. It can be performed for individual and corporate investors.
The main purpose of rebalancing is to maintain the risk exposure of the portfolio within the defined objectives of the investor.
Let us discuss what is portfolio rebalancing, how it works, and what are the different rebalancing strategies.
What is Portfolio Rebalancing?
Portfolio Rebalancing refers to the process of buying or selling assets in a portfolio to return them to the desired asset allocation according to the original investment plan.
In simple words, rebalancing is the act of returning the portfolio to the planned asset allocation in terms of the investor’s risk appetite and risk tolerance.
Every investment portfolio comes with an investment plan and sets parameters of risk, asset allocation, the required rate of return, and long-term goals.
Market performance means different results over time for different asset classes. It results in a disproportionate allocation of assets in a portfolio.
Rebalancing is then the process of adjusting the weightage of stocks, bonds, cash, and other assets in the portfolio according to the original investment plan.
The portfolio manager may have to sell or buy one or more assets in the portfolio. For example, if stocks appreciate quickly, you may have to sell some of them and buy more bonds to keep the balanced portfolio asset allocation.
In short, portfolio rebalancing is the act of balancing asset allocation again whenever it distorts from the plan.
What is Portfolio Balancing?
Portfolio balancing is the process of allocating assets according to the proportion of risk and return in the investment portfolio.
It is the act of choosing the right mix of assets and keeping a balanced proportion of these asset classes to achieve desired investment results.
Therefore, the first step is to define the portfolio investment goals and objectives. Then, you can choose different asset classes to construct the portfolio.
The asset allocation and weightage of each asset class will then depend on your investment goals.
For example, if you have a high-risk appetite and your risk tolerance is also high, and you are aiming for an aggressive return, you can allocate as high as 90% of your assets to stocks and 10% to bonds.
How Does Portfolio Rebalancing Work?
Portfolio rebalancing aims to keep asset allocation on target. Its primary purpose is to keep the investment goals within the investment plan parameters.
When market conditions change or a specific industry’s returns change, an investment portfolio may show distorted asset allocation.
The portfolio manager will then look to rebalance by selling stocks or bonds and buying the other asset to keep the portfolio balance intact.
Rebalancing a portfolio does not always mean allocation of assets in equal proportion. For example, if an investment portfolio comprises stocks, bonds, cash, and mutual funds, it does not need to allocate 25% investment to each asset class.
Rather, rebalancing is the act of keeping the desired proportion of each asset class according to the investment objectives.
Why Do You Need Portfolio Rebalancing?
The primary reason for portfolio rebalancing is to avoid undesirable risk exposure. At the same, it aims to keep the portfolio on track to achieve desired returns.
Stocks are a riskier investment than bonds and mutual funds. Therefore, if stocks appreciate and gain a higher proportion of asset allocation, it is necessary to sell some stock and buy more bonds/mutual funds to rebalance the portfolio again.
Also, investors may not have the same risk appetite and risk tolerance levels as earlier. So, if their risk profile changes, they may need to rebalance and adjust their investment portfolios accordingly.
The need of rebalancing a portfolio depends directly on the investment objectives of the investor(s). So, there is no specific time to rebalance a portfolio.
Investors may not need rebalancing for a long period and may require immediate rebalancing quite often. For long-term investment objectives, investors usually rebalance yearly.
However, it is not necessary to perform a yearly rebalancing. It all depends on the context and how the investment portfolio is performing.
Examples
Risk diversification is the main objective of balancing an investment portfolio in the first place. Therefore, portfolio rebalancing often happens to achieve this objective.
For example, an investment portfolio has three types of stocks A, B, and C. These stocks come with different risk exposure and market Beta readings.
Suppose stock A is the riskiest one and the portfolio aims to keep a maximum of 20% investment allocation for it. If Stock A appreciates exponentially, it will increase its weightage.
Let’s assume it increases to 30% of the total asset allocation. Although stock appreciation is beneficial for the investor, it increases the risk exposure.
Thus, the investor may want to sell some Stocks A and keep it to a 20% proportion again.
Similarly, conservative investments like retirement accounts look to keep the risk exposure in check. They can adjust asset allocation when their market prices change and their proportionate weightage changes.
Portfolio Rebalancing Strategies
Choosing the right rebalancing strategy depends on the target investment objectives. Some basic rebalancing strategies can be used by retail and corporate investors alike.
These strategies incur transaction costs and tax liabilities but are essential in many situations.
Here are a few commonly used portfolio rebalancing strategies.
Calendar Rebalancing
This is the basic and commonly used rebalancing approach that requires adjusting asset allocation at a predetermined time.
Most investors looking for long-term investment goals use yearly analysis to rebalance their portfolios. However, investors can determine any period like monthly, quarterly, or yearly to analyze the portfolio.
This strategy is simple to apply and incurs fewer transaction costs than other strategies.
Percentage-of-Portfolio Rebalancing
This is an aggressive rebalancing strategy that aims to keep a predetermined percentage of total assets for each asset class.
For example, an investor may aim to keep 60% stocks, 30% bonds, and 10% cash. If any of these values distort, a rebalancing should bring back the portfolio to the same percentage allocation again.
Smart Beta Rebalancing
This strategy is commonly used by index investors. It follows a rule-based approach to asset allocation by defining a performance metric like book value or ROCE.
This approach is taken to avoid overreliance on index investing that directly relates to market capitalization and can be affected by market inefficiencies.
A Smart beta strategy can also be applied to stock and other investments if proper performance metrics are defined.
Constant Proportion Portfolio Insurance Rebalancing
The CPPI rebalancing sets a minimum dollar value of the portfolio and adjusts each asset class accordingly. It is mainly an approach to provide portfolio insurance to keep a proportion of the total investment in conservative assets to avoid risk exposure.
CPPI argues that an investor’s risk exposure increases as its wealth increases. So, it’s necessary to keep a predefined minimum proportion of the total investment in the form of cash or conservative assets like bonds.
An increase in the value of a portfolio usually results in a higher value of stocks. Therefore, CPPI brings a balance to the investment by allocating more investment to cash, government bonds, or similar securities.
Advantages of Portfolio Rebalancing
Portfolio rebalancing brings several advantages to investors.
- Rebalancing is the process of keeping a track record of an investment portfolio. If the portfolio distorts, it brings back the balance.
- It keeps the risk exposure to a predefined level and keeps the investment within the risk tolerance and risk appetite of the investor.
- It helps investors follow the golden principle of “buy low and sell high” when some assets appreciate without waiting for a further hike.
- It avoids emotional thinking and hence reduces risks for the investors.
- Rebalancing can be performed at any time and the strategy may change with a change in the needs of the investor.
- It helps investors to reassess their risk profile and risk tolerance and adjust their long-term financial objectives.
Disadvantages of Portfolio Rebalancing
Portfolio rebalancing comes with certain limitations and disadvantages for investors as well.
- It requires specific skills and can be done by portfolio managers or experienced individual investors.
- Selling appreciating securities quickly may come with an opportunity cost of high profits for investors.
- All rebalancing strategies come with some sort of transaction costs that may reduce the net income of the portfolio.
- Rebalancing is not a mandatory practice and it may lead to unnecessary costs for investors.
Some investors may lack the knowledge and expertise to analyze market risks and align them to their individual risk profiles.
