Rebalancing

What Is Rebalancing?

Rebalancing is the process of adjusting a portfolio back to its original or desired asset allocation. It falls under the broader category of Portfolio Management and is crucial for maintaining an investor's intended Risk Tolerance over time. As different assets perform differently, their proportional weightings within a portfolio naturally drift from the target allocation. Rebalancing involves selling appreciated assets and buying underperforming ones to restore the predefined percentages, thus helping to manage portfolio risk rather than chasing returns²², ²³. This systematic adjustment ensures that the portfolio's risk-and-return characteristics remain aligned with the investor's Investment Goals.

History and Origin

While the concept of maintaining a diversified portfolio has existed for decades, the practice of systematic rebalancing gained prominence with the rise of modern portfolio theory and the increasing accessibility of diversified investment vehicles. As passive investing strategies, particularly those involving Index Funds and Exchange-Traded Funds (ETFs), became more widespread, the mechanical nature of rebalancing became a cornerstone for disciplined investors. Financial institutions and academic research have extensively explored rebalancing strategies to understand their impact on long-term portfolio performance and risk management. For instance, Vanguard, a leading investment management company, has conducted significant research on optimal rebalancing practices, emphasizing its role in maintaining a portfolio's target risk profile²⁰, ²¹.

Key Takeaways

• Rebalancing is the process of realigning a portfolio's asset weights to its target allocation.
• Its primary goal is to manage risk and maintain the investor's desired risk exposure, not to maximize returns¹⁸, ¹⁹.
• Portfolio drift occurs naturally as different asset classes experience varying returns.
• Rebalancing typically involves selling assets that have grown disproportionately and buying those that have shrunk.
• Common rebalancing methods include calendar-based, threshold-based, or a combination of both.

Formula and Calculation

Rebalancing does not typically involve a complex universal formula, as it is a process of adjustment rather than a calculation of a single metric. Instead, it relies on comparing current asset weights to target weights.

The fundamental concept is:

$\text{Current Allocation}_i = \frac{\text{Current Market Value of Asset}_i}{\text{Total Portfolio Market Value}}$

Where:

• (\text{Current Allocation}_i) represents the current percentage of asset (i) in the portfolio.
• (\text{Current Market Value of Asset}_i) is the current value of a specific asset or asset class (e.g., Equities or Bonds).
• (\text{Total Portfolio Market Value}) is the sum of the current market values of all assets in the portfolio.

Once the current allocation is determined, it is compared to the target allocation outlined in an investor's Investment Policy Statement (IPS). Any discrepancies then dictate the rebalancing trades. For example, if a target is 60% equities and 40% bonds, but equities have grown to 65% and bonds shrunk to 35%, the rebalancing action would involve selling equities and buying bonds to restore the 60/40 ratio.

Interpreting the Rebalancing

Interpreting rebalancing involves understanding its purpose: to manage risk by adhering to a predefined Asset Allocation. A portfolio that is not rebalanced can gradually become riskier than intended if its high-performing assets, typically equities, grow to represent a larger proportion of the total portfolio value. Conversely, a portfolio might become too conservative if safer assets significantly outperform.

Rebalancing ensures that the portfolio's risk profile remains consistent with the investor's Risk Tolerance and long-term financial objectives. It is not about timing the market or maximizing short-term gains, but rather about maintaining discipline and preventing portfolio drift¹⁷. Successful interpretation of rebalancing means recognizing it as a risk management tool that helps investors "stay the course" during various market conditions, including periods of Market Volatility.

Hypothetical Example

Consider an investor, Sarah, who sets up a simple portfolio with a target asset allocation of 70% Equities and 30% Bonds. Her initial investment is $100,000, so she invests $70,000 in an equity ETF and $30,000 in a bond ETF.

After one year, the equity market experiences a strong bull run, and her equity ETF grows by 20%, while her bond ETF remains relatively flat with a 2% gain.

• Initial Portfolio:

  • Equities: $70,000 (70%)
  • Bonds: $30,000 (30%)
  • Total: $100,000

• After One Year:

  • Equities: $70,000 * (1 + 0.20) = $84,000
  • Bonds: $30,000 * (1 + 0.02) = $30,600
  • New Total: $84,000 + $30,600 = $114,600

• Current Allocation:

  • Equities: $84,000 / $114,600 ≈ 73.30%
  • Bonds: $30,600 / $114,600 ≈ 26.70%

Sarah's portfolio has drifted from her 70/30 target to approximately 73.30/26.70. To rebalance, she would sell approximately $3,770 of her equity ETF ($84,000 - ($114,600 * 0.70) = $84,000 - $80,220) and use those proceeds to buy more of her bond ETF ($30,600 + $3,770 = $34,370, which is $114,600 * 0.30), bringing her portfolio back to the 70/30 allocation. This action brings her portfolio back into alignment with her desired Diversification and risk profile.

Practical Applications

Rebalancing is a core practice in various areas of investing and financial planning:

• Individual Investor Portfolios: For individual investors, rebalancing is a critical component of managing their long-term investment portfolios, especially those following a passive investing philosophy with diversified Mutual Funds or ETFs. It helps them adhere to their chosen Asset Allocation and manage their exposure to different market risks.
• Retirement Planning: As investors approach retirement, rebalancing strategies often involve gradually shifting from higher-risk growth assets to lower-volatility, income-generating investments to preserve capital.
• Robo-Advisors: Many robo-advisory platforms automate the rebalancing process, adjusting client portfolios based on predefined algorithms and thresholds, making it accessible even for novice investors.
• Institutional Asset Management: Large institutional investors, such as pension funds and endowments, regularly rebalance their vast portfolios to maintain strict adherence to their investment mandates and control risk.
• Tax Considerations: Investors must consider the tax implications of rebalancing, particularly in Taxable Accounts. Selling appreciated assets can trigger Capital Gains taxes. The Internal Revenue Service (IRS) provides guidance on investment income and expenses in Publication 550, which details how to report gains and losses from such transactions.
• ¹⁶ Market Volatility Management: During periods of significant Market Volatility, rebalancing can become more frequent as asset values fluctuate wildly. Exchanges often see increased trading volumes as investors adjust their portfolios in response to market shifts.

#¹⁵# Limitations and Criticisms

While rebalancing is a widely accepted practice for risk management, it does have limitations and criticisms:

• Potential for Lower Returns: Some argue that continuous rebalancing can slightly dampen overall Risk-Adjusted Returns in consistently rising markets, as it involves selling winners and buying losers. For instance, if equities are in a prolonged bull market, rebalancing means selling off a portion of the outperforming asset, potentially limiting overall growth.
• ¹⁴ Transaction Costs: Frequent rebalancing can incur transaction costs, such as brokerage commissions or bid-ask spreads, which can erode returns, especially for smaller portfolios or highly active strategies.
• Tax Implications: As mentioned, rebalancing in taxable brokerage accounts can trigger capital gains taxes, which could reduce net returns. Investors often prioritize rebalancing within tax-advantaged accounts (like IRAs or 401(k)s) to avoid immediate tax consequences.
• ¹³ Behavioral Challenges: The act of selling assets that have performed well and buying those that have performed poorly can be counter-intuitive and emotionally challenging for some investors, potentially leading to a lack of discipline. The Bogleheads community, known for its emphasis on long-term passive investing, advocates for disciplined rebalancing but also acknowledges the behavioral aspects involved.
• ¹² No "Optimal" Strategy: Research suggests there is no single "optimal" frequency or threshold for rebalancing that universally maximizes returns or minimizes risk. The "best" approach often depends on individual circumstances, including tax considerations, portfolio size, and an investor's willingness to monitor their holdings.

#¹⁰, ¹¹# Rebalancing vs. Asset Allocation

Asset Allocation and rebalancing are closely related but distinct concepts within Portfolio Management.

Asset Allocation is the strategic decision of how to divide an investment portfolio among different asset classes, such as Equities, Bonds, and cash, based on an investor's Risk Tolerance, Investment Goals, and time horizon. It is the initial blueprint for the portfolio, determining the target percentages for each asset class. For example, a common asset allocation might be 60% equities and 40% bonds.

Rebalancing, on the other hand, is the active process of maintaining that chosen asset allocation over time. Market movements cause the initial asset allocation to drift, as some asset classes will outperform others, increasing their weight in the portfolio. Rebalancing is the act of bringing the portfolio back to its original target percentages by selling overweighted assets and buying underweighted ones. While asset allocation sets the strategic long-term vision, rebalancing provides the tactical adjustments needed to stay true to that vision.

FAQs

How often should a portfolio be rebalanced?

The frequency of rebalancing can vary. Common approaches include calendar-based rebalancing (e.g., annually or semi-annually) or threshold-based rebalancing, where adjustments are made only when an asset class deviates by a certain percentage (e.g., 5% or 10%) from its target allocation. Re⁷, ⁸, ⁹search suggests that annual rebalancing is often a practical and effective strategy for many investors.

#⁵, ⁶## Is rebalancing always necessary?
Rebalancing is generally recommended to manage risk and maintain a portfolio's alignment with an investor's intended Risk Tolerance. Without it, a portfolio can drift significantly, potentially exposing an investor to more risk than they are comfortable with or less potential return than desired. However, for investors with very long time horizons and a high Risk Tolerance, the necessity can be debated, especially if managing Capital Gains taxes in Taxable Accounts is a primary concern.

#³, ⁴## What happens if you don't rebalance?
If a portfolio is never rebalanced, its Asset Allocation will naturally drift over time due to varying asset returns. Typically, higher-returning asset classes, such as equities, will grow to represent a larger portion of the portfolio. This can lead to a higher overall portfolio risk than initially intended, as the portfolio becomes more concentrated in volatile assets. Conversely, a portfolio might become too conservative if safer assets significantly outperform.

Can rebalancing improve returns?

The primary goal of rebalancing is to manage risk and maintain a consistent Risk Tolerance, not necessarily to maximize returns. While some studies suggest a potential "rebalancing bonus" in certain market conditions, other research indicates that frequent rebalancing may slightly dampen returns compared to a never-rebalanced portfolio, particularly in a persistent bull market. Th¹, ²e benefit often comes from the controlled risk and disciplined approach rather than superior returns.