What is Rebalancing?

When it comes to your investment portfolio, one of the primary things an investor has control over is their asset allocation. At the simplest level, this means the percentage of their overall portfolio invested in stocks as compared to bonds.

As intelligent investors know it is asset allocation, not security selection, that should be counted on to drive the vast majority of returns in the portfolio. And for that reason, the primary decision, and the core of a sound investment policy statement (IPS), should be centered on asset allocation.

In addition, it is important that the selected asset allocation be maintained over time to ensure that the risk of the portfolio does not become materially higher or lower than the investor’s objectives require.

The process of maintaining the portfolio’s target asset allocation is known as rebalancing the portfolio. To provide some context, let’s walk through the basics of asset allocation and rebalancing.

The Basics

At the outset, an investor should select a target asset allocation based on their unique ability, willingness, and need to take risk. The target asset allocation should carry with it only as much risk as is necessary to provide the investor with a high probability of achieving their stated goal, but no more.

In other words, an investor’s time horizon (ability to take risk), their tolerance for market volatility (willingness to take risk), and their financial objectives or spending requirements (need to take risk) should be reconciled to determine the minimum (needed) and maximum (willingness) level of risk for the portfolio.

However, because the investments in a portfolio do not always move in the same direction or with the same magnitude, over time that asset allocation will almost certainly change.

It is for this reason that a portfolio must be regularly monitored and adjusted back to target (or rebalanced) when it deviates from the target allocation.

An Example

Let’s walk through an example of what that looks like:

To make the math easy, let’s say we have an initial portfolio of $1 million and our target asset allocation is 60% stocks and 40% bonds. So our asset allocation looks like this:

Stocks: $600,000 (60%)
Bonds: $400,000 (40%)

Total: $1,000,000

After investing the portfolio to achieve our target allocation, let’s assume stocks go on a wonderful run (as they often do), increasing 30% over the subsequent 12 months. Meanwhile, the value of the bond part of our portfolio, although having moved up and down a little bit during the year, has ended where it began. Thus, our new asset allocation looks like this:

Stocks: $780,000 (66%)
Bonds: $400,000 (34%)

Total: $1,180,000

Clearly this portfolio looks different from our target asset allocation, as stocks are six percentage points overweight (10% on a relative basis) and bonds are six percentage points underweight (15% on a relative basis).

In this case, depending on the parameters defined in your IPS, it is probably time to rebalance the portfolio back to our target allocation of 60% stocks and 40% bonds. Specifically, we want our newly rebalanced portfolio to look like this:

Stocks: $708,000 (60%)
Bonds: $472,000 (40%)

Total: $1,180,000

In order to do this, we would need to sell $72,000 in stocks and subsequently buy $72,000 in bonds to achieve our target asset allocation once again. This will allow us to realign the portfolio’s risk level with the client’s risk profile and their financial plan.

Things to Keep in Mind

It should be noted that investors are wise to pay attention to the tax implications and the trading costs of executing such a rebalance, as sometimes the benefit can be outweighed by the expense.

It’s also important to remember that this is a simple example, with only two asset classes: stocks and bonds.

Although most portfolios can be summarized this way, the opportunity for lower risk and higher expected returns means that a truly diversified portfolio will typically have many more asset classes. The monitoring and rebalancing of such a portfolio can be much more complex and often necessitates advanced software and technology.

Finally, although understanding the process of rebalancing is important, the bigger question is this: Why do we take the time and effort to rebalance a portfolio?

In the next post, we’ll discuss these reasons and several other considerations investors should keep in mind when monitoring their asset allocation and rebalancing their portfolio.

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