Herbalancering: Definition, Example, and FAQs

What Is Herbalancering?

Herbalancering, often referred to as "portfolio rebalancing," is a crucial aspect of portfolio management in finance. It involves the disciplined process of realigning a portfolio's asset allocation back to its original or target weights. Over time, the market performance of different asset classes, such as equities and bonds, can cause a portfolio's actual allocation to drift away from an investor's desired target allocation. Herbalancering ensures that an investment portfolio remains consistent with an investor's predetermined risk tolerance and investment goals.

History and Origin

The fundamental principles underpinning portfolio rebalancing, or Herbalancering, can be traced back to the broader development of modern portfolio theory. Economist Harry Markowitz introduced the concept of Modern Portfolio Theory (MPT) in his seminal 1952 paper, "Portfolio Selection," published in The Journal of Finance.²³, ²⁴, ²⁵, ²⁶ MPT provided a mathematical framework for constructing diversified portfolios that maximize expected returns for a given level of risk.²⁰, ²¹, ²² While Markowitz's initial work focused on optimizing portfolio selection, the need for ongoing rebalancing naturally emerged as a practical application to maintain the desired risk-return profile in dynamic markets. The concept of rebalancing itself, the idea of adjusting allocations to control risk, existed in practice even before formal academic frameworks. It helps to prevent a portfolio from becoming too risky or too conservative as asset values fluctuate.

Key Takeaways

• Herbalancering is the process of adjusting a portfolio's asset allocation back to its target weights.
• It is essential for maintaining a consistent risk tolerance and aligning with long-term investment goals.
• Rebalancing strategies can be time-based (e.g., annually) or threshold-based (e.g., when an asset class deviates by a certain percentage).
• The practice can help manage portfolio risk, but it may also incur transaction costs and potentially reduce returns in continuously trending markets.
• Herbalancering helps investors maintain discipline and avoid emotional decision-making during periods of market volatility.

Interpreting Herbalancering

Herbalancering is not about predicting market movements or maximizing short-term gains; rather, it is a risk management strategy. By periodically re-aligning a portfolio, investors ensure that their exposure to different asset classes remains consistent with their initial strategic decisions. If a specific asset class, such as equities, experiences significant growth, its weight in the portfolio will naturally increase. Without Herbalancering, this drift could lead to an unintended increase in overall portfolio risk, as the portfolio becomes overweighted in more volatile assets. Conversely, an underperforming asset class could lead to a portfolio becoming too conservative. Herbalancering helps maintain the intended balance between growth potential and desired risk levels, mitigating the impact of systematic risk and unsystematic risk.

Hypothetical Example

Imagine an investor, Sarah, who starts with a diversified portfolio of $100,000, aiming for a target allocation of 60% equities and 40% bonds.

• Initial Portfolio: $60,000 in equities, $40,000 in bonds.
• After one year, due to strong stock market performance, her equities grow to $75,000, while her bonds remain stable at $40,000.
• New Portfolio Value: $115,000.
• New Allocation: Equities now represent approximately 65.2% ($75,000 / $115,000) and bonds 34.8% ($40,000 / $115,000).
• To perform Herbalancering and return to her original 60/40 target, Sarah would sell approximately $6,000 worth of equities ($75,000 - 0.60 * $115,000 = $75,000 - $69,000 = $6,000) and use that money to buy bonds, bringing her equity allocation back to $69,000 and bonds up to $46,000. This process ensures her portfolio's risk level aligns with her long-term plan.

Practical Applications

Herbalancering is a common practice across various investment vehicles and strategies. For individual investors, it's often applied to broadly diversified portfolios consisting of low-cost index funds or exchange-traded funds (ETFs) held in retirement accounts or taxable brokerage accounts. Many robo-advisors and automated investment platforms utilize algorithms to perform regular, often daily, monitoring and automatic rebalancing based on predefined rules.¹⁹ Institutional investors, such as pension funds and endowments, also regularly engage in rebalancing to maintain their desired asset allocation in line with their long-term liabilities and objectives.¹⁸ The Bogleheads community, for instance, provides detailed guidance on various rebalancing strategies, including time-based (e.g., annual) and threshold-based approaches, to help investors stay on track with their diversification goals.¹⁵, ¹⁶, ¹⁷ Charles Schwab also highlights that rebalancing helps keep a portfolio's intended level of risk consistent over time.¹², ¹³, ¹⁴

Limitations and Criticisms

While widely adopted, Herbalancering is not without its limitations and criticisms. One significant concern is the potential for transaction costs, including trading fees and capital gains taxes, which can erode returns, especially with frequent rebalancing or in taxable accounts.¹⁰, ¹¹ Some critics also argue that rebalancing can potentially reduce long-term returns in environments where one asset class consistently outperforms others, as it involves selling winners and buying losers.⁸, ⁹ Research suggests that while rebalancing helps control risk, its ability to consistently enhance returns, particularly between asset classes with materially different returns, is debatable.⁷ Furthermore, predictable rebalancing by large institutional investors can create opportunities for "front-running" by algorithmic traders, potentially leading to additional costs for the rebalancing funds.⁶ A 2023 Reuters article noted that "The dirty secret of rebalancing: It might not work" in all scenarios, especially when considering the costs and the potential for dampening returns in strong bull markets.⁵

Herbalancering vs. Strategic Asset Allocation

Herbalancering (portfolio rebalancing) and strategic asset allocation are closely related but distinct concepts in portfolio management.

• Strategic Asset Allocation is the initial, long-term decision about the ideal mix of different asset classes in a portfolio, based on an investor's risk tolerance, investment goals, and time horizon. It sets the desired percentages (e.g., 60% equities, 40% bonds). This is a forward-looking decision that establishes the core investment strategy.
• Herbalancering is the ongoing tactical process of maintaining that chosen strategic asset allocation. It is the act of periodically adjusting the portfolio back to its original target percentages after market movements have caused it to drift. While strategic asset allocation defines the "what," Herbalancering defines the "how" of staying true to that strategy.

The confusion often arises because both involve adjusting the mix of assets. However, strategic asset allocation is the foundation, and Herbalancering is the maintenance process that keeps the portfolio aligned with that foundation.

FAQs

What is the primary goal of Herbalancering?

The primary goal of Herbalancering is to manage and control portfolio risk by ensuring that the asset allocation remains aligned with the investor's predetermined risk tolerance and investment goals. It is not primarily focused on maximizing returns.

How often should a portfolio be rebalanced?

The ideal rebalancing frequency varies by investor, market conditions, and personal preference. Common approaches include time-based rebalancing (e.g., annually or semi-annually) or threshold-based rebalancing (e.g., when any asset class deviates by a certain percentage, such as 5% or 10%).³, ⁴

Does Herbalancering guarantee higher returns?

No, Herbalancering does not guarantee higher returns. Its main purpose is risk management. In some market conditions, particularly strong bull markets, a "buy and hold" strategy that allows winners to run might outperform a rebalanced portfolio. However, rebalancing can help reduce portfolio volatility and prevent excessive exposure to specific risks.²

What happens if I don't rebalance my portfolio?

If a portfolio is not subjected to Herbalancering, its asset allocation will naturally drift over time due to differing returns among asset classes. This drift can lead to an unintended increase or decrease in the portfolio's overall risk tolerance, potentially exposing the investor to more risk than desired or causing the portfolio to become too conservative to meet long-term investment goals.¹