Rebalancing

What Is Rebalancing?

Rebalancing is a core practice within Portfolio Management that involves adjusting a portfolio to restore its original or desired asset allocation. Over time, the differing performance of various asset classes can cause the portfolio's actual allocation to drift away from an investor's established target allocation. Rebalancing typically involves selling assets that have performed well and have become overweighted, and using the proceeds to buy assets that have underperformed and become underweighted, thereby bringing the portfolio back to its intended risk-return profile. This systematic adjustment helps maintain the portfolio's alignment with an investor's risk tolerance and investment goals.

History and Origin

The concept of managing a portfolio based on risk and return, which underpins rebalancing, gained prominence with the advent of Modern Portfolio Theory (MPT). Pioneered by economist Harry Markowitz in the 1950s, MPT emphasized the importance of diversification and the relationship between risk and return in portfolio construction. Markowitz's seminal paper, "Portfolio Selection," published in 1952, laid the theoretical groundwork for optimizing portfolios not just by selecting individual securities, but by considering how different assets move in relation to one another.³¹, ³², ³³, ³⁴ While Markowitz's work formalized the understanding of portfolio diversification, the practical application of periodically adjusting a portfolio to maintain a desired mix can be traced back earlier. The practice of rebalancing ensures that a portfolio continues to adhere to the risk-return characteristics initially designed, rather than allowing market forces to dictate its composition.³⁰

Key Takeaways

• Risk Control: Rebalancing helps maintain a portfolio's intended risk level by preventing any single asset class from becoming overly dominant due to strong performance.²⁸, ²⁹
• Disciplined Approach: It enforces a "buy low, sell high" discipline, as investors sell appreciated assets and purchase those that have lagged.²⁶, ²⁷
• Goal Alignment: Regular rebalancing ensures the portfolio remains aligned with an investor's long-term investment horizon and financial objectives.²⁴, ²⁵
• Mitigates Drift: It corrects for portfolio drift caused by varying return on investment among different holdings.

Formula and Calculation

While there isn't a single "rebalancing formula," the process involves calculating the current weight of each asset in a portfolio and comparing it to the target weight. The deviation determines the necessary trades.

The weight of an asset is calculated as:

For example, if an investor's target allocation is 60% stocks and 40% bonds, and due to market volatility, stocks now represent 70% of the portfolio, the rebalancing calculation would involve determining the amount of stock to sell and bonds to buy to restore the 60/40 ratio.

Interpreting Rebalancing

Rebalancing is interpreted as a tool for proactive risk management rather than a strategy to maximize returns.²¹, ²², ²³ By regularly bringing a portfolio back to its predetermined asset allocation, investors consciously manage their exposure to market fluctuations. If a portfolio's equity component grows significantly during a bull market, rebalancing involves selling some of those equities. This action reduces potential downside risk should the market decline, even though it might mean foregoing some additional gains if the bull market continues. Conversely, during a downturn, rebalancing may involve buying more of a depreciated asset, which can be counter-intuitive but aligns with the long-term strategic plan.¹⁹, ²⁰

Hypothetical Example

Consider an investor who starts with a $100,000 portfolio and a target allocation of 60% stocks and 40% bonds.

• Initial Portfolio: $60,000 in stocks, $40,000 in bonds.

After one year, suppose the stock portion of the portfolio grows by 25%, while the bond portion remains flat.

• Stocks: $60,000 * 1.25 = $75,000
• Bonds: $40,000
• Total Portfolio Value: $75,000 + $40,000 = $115,000

The new allocation is:

• Stocks: $75,000 / $115,000 ≈ 65.2%
• Bonds: $40,000 / $115,000 ≈ 34.8%

To rebalance back to 60% stocks and 40% bonds for the $115,000 portfolio:

• Desired Stock Value: $115,000 * 0.60 = $69,000
• Desired Bond Value: $115,000 * 0.40 = $46,000

The investor would need to sell $75,000 - $69,000 = $6,000 worth of stocks and use that $6,000 to buy additional bonds. This process ensures the portfolio's risk profile returns to the investor's predetermined comfort level.

Practical Applications

Rebalancing is a fundamental practice across various investment contexts. In personal financial planning, individuals use rebalancing to ensure their portfolios continue to match their evolving risk tolerance as they approach different life stages, such as retirement. For institutional investors, such as pension funds, rebalancing is a critical component of their fiduciary duty to maintain their desired risk-return profiles and meet long-term liabilities. It ¹⁷, ¹⁸is also integral to the management of target-date funds, which automatically rebalance to a more conservative asset allocation as the target retirement date approaches. Rebalancing considerations often intersect with tax efficiency strategies, as selling appreciated assets can trigger capital gains taxes. Therefore, investors often prioritize rebalancing within tax-advantaged accounts to minimize tax implications.

##¹⁶ Limitations and Criticisms
While rebalancing offers significant benefits in terms of risk management and disciplined investing, it does have limitations. One criticism is that constant rebalancing can lead to increased transaction costs, which can erode returns over time, especially for smaller portfolios or those with high-frequency rebalancing. Another concern is that by selling winning assets, an investor might miss out on further gains if those assets continue to outperform. Conversely, buying underperforming assets means committing more capital to investments that may continue to lag. Som¹⁵e studies suggest that while rebalancing reliably reduces risk, it does not necessarily improve returns, particularly when asset classes do not behave significantly differently. Fur¹⁴thermore, predictable rebalancing schedules by large institutional investors can, in some instances, create opportunities for front-running, potentially costing these investors billions of dollars annually. The¹³ effectiveness of a rebalancing strategy can also be influenced by market conditions; in strong, sustained bull markets, a "buy and hold" approach might outperform, albeit with higher risk.

##¹² Rebalancing vs. Asset Allocation
While often discussed together, rebalancing and asset allocation are distinct but complementary concepts in strategic asset allocation. Asset allocation refers to the strategic decision of how an investor's capital is distributed among different asset classes (e.g., stocks, bonds, cash) to align with their investment goals, risk tolerance, and investment horizon. It establishes the target percentages for each asset class. Rebalancing, on the other hand, is the process of adjusting the portfolio over time to ensure it adheres to that predefined asset allocation. If a portfolio's actual allocation drifts away from the target due to market movements, rebalancing brings it back into line. Asset allocation is the "what" (the target mix), while rebalancing is the "how" (the action taken to maintain that mix).

FAQs

Why is rebalancing important?

Rebalancing is crucial for maintaining your portfolio's intended risk profile. Without it, market fluctuations can cause certain asset classes to grow disproportionately, leading to a riskier or more conservative portfolio than originally desired. It ¹¹helps ensure your investments remain aligned with your personal investment goals and risk tolerance.

How often should a portfolio be rebalanced?

The frequency of rebalancing depends on individual preferences, portfolio size, and market conditions. Common approaches include calendar-based rebalancing (e.g., annually, semi-annually, or quarterly) or threshold-based rebalancing, where adjustments are made only when an asset class deviates from its target allocation by a certain percentage (e.g., 5% or 10%). The⁹, ¹⁰ key is consistency and having a plan.

Does rebalancing improve investment returns?

Not necessarily. The primary goal of rebalancing is to manage risk and maintain a consistent asset allocation aligned with an investor's objectives. Whi⁸le it can force a "buy low, sell high" discipline, historically, a buy-and-hold strategy in strong bull markets might sometimes yield higher returns, albeit with greater market volatility and potential for greater drawdowns.

##⁷# Are there tax implications when rebalancing?
Yes, rebalancing in taxable accounts can trigger capital gains or losses. Selling appreciated assets will realize capital gains, which may be subject to taxation. For⁵, ⁶ this reason, many investors prefer to rebalance within tax-advantaged accounts, such as 401(k)s or IRAs, where transactions do not immediately trigger taxes. Tax³, ⁴-loss harvesting can also be considered in conjunction with rebalancing in taxable accounts.

What happens if I don't rebalance my portfolio?

If a portfolio is not rebalanced, its asset allocation will naturally drift over time due to differing return on investment among its holdings. This drift can lead to a portfolio that is significantly riskier or more conservative than originally intended, potentially jeopardizing the achievement of long-term investing goals.¹, ²