Reordering

What Is Rebalancing?

Rebalancing, also known as reordering, is the process of adjusting an investment portfolio's asset allocation back to its original target percentages. This crucial component of portfolio management falls under the broader category of portfolio theory, aiming to maintain a desired risk tolerance and investment strategy over time. As market conditions fluctuate, the values of different assets within a portfolio will inevitably drift, causing some asset classes to grow larger than their intended allocation and others to shrink. Rebalancing involves selling appreciated assets and buying more of those that have underperformed to restore the portfolio to its predetermined mix. This disciplined approach helps investors manage risk and adhere to their long-term investment plan.

History and Origin

The concept of rebalancing can be traced back centuries, even before modern financial theory formalized it. One of the earliest proponents of a rebalancing-like strategy was Jakob Fugger, a prominent German merchant and banker in the 15th and 16th centuries. He advised dividing fortunes into four equal parts—stocks, real estate, bonds, and gold coins—and to rebalance whenever performance differences caused a major imbalance. Fugger's approach underscored the importance of maintaining a diversified portfolio to navigate fluctuating markets.

I¹⁷n the mid-20th century, economist Harry Markowitz's Modern Portfolio Theory, for which he later received a Nobel Prize, provided the academic foundation for asset allocation and the role of rebalancing. Markowitz's work demonstrated that combining different, unrelated assets could significantly reduce the overall portfolio risk. Fu¹⁶rther solidifying the importance of asset allocation, a landmark 1986 study by Gary Brinson, L. Randolph Hood, and Gilbert Beebower found that asset allocation was the primary determinant of a portfolio's returns variation, rather than security selection or market timing. Th¹⁵is academic validation cemented rebalancing as a fundamental practice in investment management.

Key Takeaways

• Rebalancing is the process of adjusting a portfolio's asset allocation back to its target percentages.
• It is essential for maintaining an investor's desired risk level and long-term investment strategy.
• Rebalancing involves selling overperforming assets and buying underperforming ones.
• Common rebalancing strategies include time-based (e.g., annual) and threshold-based (e.g., when an asset deviates by a certain percentage).
• While it helps manage risk, rebalancing can incur transaction costs and potential capital gains taxes.

Formula and Calculation

Rebalancing does not typically involve a single, universal formula but rather a set of calculations to determine the necessary adjustments to return to the target asset allocation. The core idea is to calculate the current weight of each asset class and then determine the buy/sell amounts needed to realign with the target weights.

Let:

• ( W_i^{\text{target}} ) = Target weight of asset class ( i )
• ( V_i^{\text{current}} ) = Current market value of asset class ( i )
• ( V_{\text{total}}^{\text{current}} ) = Current total portfolio value

The current weight of asset class ( i ) is calculated as:

To find the desired value of asset class ( i ) in the portfolio after rebalancing:

The amount to buy or sell for asset class ( i ) is then:

A positive result indicates a need to buy, while a negative result indicates a need to sell. These adjustments are made by purchasing or selling stocks, bonds, or other investments.

Interpreting the Rebalancing

Interpreting rebalancing means understanding its purpose and how it aligns with an investor's financial objectives. When a portfolio drifts from its original asset allocation, it often implies a change in the portfolio's overall risk profile. For example, if stocks have significantly outperformed bonds, a portfolio initially set at 60% stocks and 40% bonds might become 70% stocks and 30% bonds. This shift means the portfolio has become riskier than originally intended.

Rebalancing is interpreted as a disciplined act to bring the portfolio back into alignment with the investor's predetermined risk tolerance. It's not about predicting future market movements or maximizing short-term gains but rather about managing risk and ensuring the portfolio remains suitable for the investor's long-term goals. It reinforces the idea that an investment strategy is a dynamic process requiring periodic adjustments, especially in response to market volatility.

#¹⁴# Hypothetical Example

Consider an investor, Sarah, who established a diversified portfolio with a target allocation of 60% equities and 40% bonds, reflecting her moderate risk tolerance. Her initial investment was $100,000, meaning $60,000 in equities and $40,000 in bonds.

After one year, due to strong market performance, her equity investments have grown to $75,000, while her bond investments remain at $40,000. Her total portfolio value is now $115,000.

Current Allocation:

• Equities: ($75,000 / $115,000) = 65.2%
• Bonds: ($40,000 / $115,000) = 34.8%

Sarah's portfolio has drifted from her target 60/40 mix, becoming riskier with a higher equity exposure. To rebalance, she needs to:

1. Calculate desired values:
   • Desired Equities: 60% of $115,000 = $69,000
   • Desired Bonds: 40% of $115,000 = $46,000
2. Determine adjustments:
   • Sell Equities: $75,000 (current) - $69,000 (desired) = $6,000
   • Buy Bonds: $46,000 (desired) - $40,000 (current) = $6,000

Sarah would sell $6,000 worth of her equity holdings and use those proceeds to buy $6,000 worth of bonds, bringing her portfolio back to the 60/40 target asset allocation of $69,000 in equities and $46,000 in bonds.

Practical Applications

Rebalancing is a fundamental practice across various facets of finance and investment management. In personal investing, individuals and financial advisors use rebalancing to ensure portfolios remain aligned with an investor's financial goals and risk tolerance. Th¹³is is particularly important for long-term strategies, such as retirement planning, where a consistent asset allocation is key. Many automated investment platforms and robo-advisors offer automatic rebalancing services, making the process seamless for investors.

F¹²urthermore, rebalancing is a core feature of many pooled investment vehicles like target-date funds, which automatically adjust their asset mix to become more conservative as the target retirement date approaches. It¹¹ is also employed by institutional investors, pension funds, and endowments to maintain specific portfolio objectives and manage exposure to different market sectors. When implementing rebalancing, investors must consider potential transaction costs and the tax implications, such as capital gains incurred from selling appreciated assets,. F¹⁰o⁹r specific guidance on capital gains, the Internal Revenue Service provides detailed information on its website IRS.gov. The Bogleheads community also offers extensive discussions on various rebalancing strategies Bogleheads.org.

Limitations and Criticisms

While rebalancing is widely advocated for its role in risk management, it is not without limitations or criticisms. One primary concern is that rebalancing inherently means selling assets that have performed well and buying those that have underperformed. This can lead to investors potentially missing out on further gains if the strong-performing assets continue their upward trend,. Th⁸e goal of rebalancing is risk control and adherence to a chosen asset allocation, not maximizing returns.

A⁷nother limitation is the potential for increased transaction costs, especially with frequent rebalancing, which can erode overall portfolio returns. Ad⁶ditionally, selling appreciated assets can trigger capital gains taxes in taxable brokerage accounts, reducing the net return. This necessitates careful consideration of tax-efficient rebalancing strategies, such as tax-loss harvesting or utilizing tax-advantaged accounts like IRAs or 401(k)s, where capital gains are not taxed until withdrawal,. S⁵o⁴me critics also argue that overly frequent rebalancing can be detrimental, suggesting that a less active approach may sometimes be more beneficial Morningstar.com. The effectiveness of rebalancing often depends on market conditions; in strong bull markets, selling winners might seem counterproductive, while in volatile or bear markets, it can prove invaluable for preserving capital and managing risk-adjusted returns.

Rebalancing vs. Asset Allocation

Rebalancing and asset allocation are closely related but distinct concepts in portfolio management.

Asset allocation is the strategic decision of how an investment portfolio's assets are distributed among different asset classes, such as stocks, bonds, and cash. This initial decision is based on an investor's objectives, risk tolerance, and time horizon. It defines the target percentages for each asset class, forming the foundation of an investment plan.

Rebalancing, conversely, is the tactical process of maintaining that chosen asset allocation over time. As market values shift, the actual weighting of asset classes in a portfolio will deviate from the original targets. Rebalancing is the act of buying and selling to bring these deviated weights back in line with the initial asset allocation strategy. Without rebalancing, a portfolio's risk profile could unknowingly drift, potentially exposing an investor to more or less risk than intended.

FAQs

How often should a portfolio be rebalanced?

The frequency of rebalancing depends on an investor's preference, market volatility, and the costs involved. Common strategies include time-based rebalancing (e.g., annually, semi-annually, or quarterly) or threshold-based rebalancing, where adjustments are made only when an asset class deviates by a certain percentage from its target. So³me target-date funds automatically rebalance on a set schedule.

Does rebalancing guarantee better returns?

No, rebalancing does not guarantee higher returns. Its primary purpose is to manage risk by ensuring the portfolio's asset allocation remains consistent with the investor's risk tolerance. It² helps maintain a disciplined approach rather than trying to time the market.

What are the potential downsides of rebalancing?

The main downsides of rebalancing include incurring transaction costs from buying and selling securities, and potentially triggering capital gains taxes on appreciated assets in taxable accounts. Th¹ere is also the possibility of missing out on further gains from assets that are sold because they have outperformed.

Can rebalancing be automated?

Yes, many financial institutions and robo-advisors offer automatic rebalancing services. This feature automatically adjusts the portfolio to maintain its target asset allocation based on pre-set rules or thresholds, removing the need for manual intervention and helping investors stick to their investment plan.

Is rebalancing necessary for all types of investments?

Rebalancing is most relevant for diversified portfolios that aim to maintain a specific mix of different asset classes. For instance, it's critical for portfolios composed of stocks and bonds. Single-asset investments like a single stock or a certificate of deposit would not require rebalancing. Similarly, individual index funds tracking a single index typically do not require rebalancing themselves, though the overall portfolio containing multiple index funds would.