What Is Portfolio Rebalancing?

Portfolio rebalancing is a key risk management strategy that helps investors navigate through cyclical markets and downtrends. Its primary goal is to help investors minimize their exposure to risk relative to their target asset allocation. In this sense, it teaches value investors that success isn’t all about maximizing returns but should also entail limiting exposure to excessive loss.

In its most basic form, portfolio rebalancing is the process of adjusting the asset weightings of one’s portfolio. You “rebalance” your portfolio by periodically buying or selling assets to maintain your original asset allocation targets.

To use a very simple example, assume that your desired portfolio allocation is 70% stocks and 30% bonds. Let’s also assume that you’ve already achieved your desired allocation. What happens if, say, stocks vastly outperform bonds? In this case, your allocation will get skewed much more in favor of stocks. If the value of your stocks increases at a significantly higher rate than your bond holdings that 70/30 allocation could become 80/20 or even 90/10 (you get the idea).

When you developed your portfolio, you set a specific allocation because it’s the one most likely to meet your investment goals and risk tolerance. This means you need to periodically rebalance the portfolio to ensure that the original allocation is maintained.

In the above example, you may need to purchase more bonds to regain your desired portfolio allocation. If you don’t, your portfolio will be skewed toward stocks more heavily than you originally intended. This may not be bad during bull markets but if stocks correct lower you will be exposed to all sorts of risks.

Against this backdrop, you now know the two main goals of portfolio rebalancing: (1) targeting risk and return characteristics and (2) controlling risks.

Want to know how to figure out your target asset allocation? Click here.

The advantages of portfolio rebalancing are numerous. For starters, asset allocation is perhaps the most important decision you will ever make as an investor. This view is shared by Vanguard, one of the world’s largest asset managers. If asset allocation is so critical, we need a method for ensuring that the allocation we targeted is the one we end up with down the road. Without it, you will quickly lose track of your original investment decision and why you chose it in the first place.

No successful value investor can get through life without a proven risk management strategy. Portfolio rebalancing offers just that and gives you a very clear framework by which to achieve it.

Rebalancing also isn’t nearly as complicated as some are led to believe. As Vanguard notes in its research, “there is no optimal frequency or threshold when selecting a rebalancing strategy.” In other words, investors have plenty of flexibility when it comes to rebalancing. This flexibility extends to frequency, asset allocation and asset selection.

Learn about other portfolio management concepts here.

Of course, no investment strategy is without its shortfalls. With respect to portfolio management, the disadvantages mostly center on opportunity cost, transaction costs and even taxes.

Investors who are rebalancing their portfolio have to conduct more trades to recapture their desired asset allocation. More trades mean more fees, including purchase and redemption costs. In addition to fees, portfolio rebalancing is a very active process, which means time and manpower costs associated with research and asset selection.

At the same time, the need to rebalance may force some investors to leave profit on the table because they are proactively managing their asset allocation. In the stocks/bonds example above, an investor may feel the need to rebalance even when stocks still have more runway to continue higher. So, in a sense, they are leaving earnings on the table.

Investors who rebalance within taxable investment accounts or vehicles may also incur capital gains taxes when they sell a portion of their assets so they can allocate the funds elsewhere. Those huge stock gains you enjoyed in the previous illustrations can carry a hefty tax payout unless sheltered in a tax-free account.

If you believe that asset allocation is important to your overall returns then you are also compelled to rebalance your portfolio to achieve that desired vision. Although portfolio allocation may seem complicated at first, the strategy is relatively straightforward because you already know the thresholds your portfolio needs to hit. This should make the asset selection process much easier.

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