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Portfolio rebalancing

Understand portfolio rebalancing, the process of adjusting asset allocations, reasons for rebalancing, methods, when to rebalance, and strategies like periodic, threshold, range, and volatility-based rebalancing. Learn how active rebalancing can optimize your investment performance.

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Portfolio rebalancing

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  1. Portfolio rebalancing

  2. Portfolio rebalancing is the process of bringing the different asset classes back into proper relationship following a significant change in one or more. More simply stated, it is returning your portfolio to the proper mix of stocks, bonds and cash when they no longer conform to your plan, when a drift occur. What is rebalancing

  3. Holding a portfolio or an asset that is overpriced and hence inferior returns. Composition of a portfolio may no longer reflect the investor’s objectives A poorly diversified portfolio, which is riskier than what an investor can bear Need for Rebalancing

  4. Changes in the attitude of the investors toward risk Changes of investment goals Liquidity needs of the investor Fluctuations in stock markets provide opportunities for both positive and negative aspects. Changes in Monetary policy, such as changes in interest rates and inflation. Need for Rebalancing

  5. Rebalancing Considerations • Rebalance at least annually • Minimize transaction costs and tax consequences by adjusting new money, not liquidating existing assets • Consider using lump-sum payments

  6. Rebalancing the portfolio involves: Either changing the securities currently included in the portfolio Or altering the proportion of funds in the securities Portfolio Rebalancing

  7. Different Strategy to decide when to Rebalance: Periodic Rebalancing Threshold Rebalancing Range Rebalancing Volatility-Based Rebalancing Active Rebalancing When to rebalance portfolio

  8. Portfolios are reset to their target allocations on a fixed schedule—such as annually, quarterly or monthly. • Assets that are overweight relative to the long-term targets are sold, and the funds used to purchase underweighted assets, until the original allocations have been restored. • This strategy has the virtue of simplicity, but can require frequent, minor adjustments. • It is also rigid, and doesn’t allow investors to temporarily overweight asset classes or sectors that are expected to outperform over the shorter term. Periodic Rebalancing

  9. Portfolios are adjusted if and when a particular asset class deviates from its target allocation by more than a certain amount—say plus or minus five percentage points. • So if, for example, the target for large-cap stocks was 60%, but a market rise caused that share to climb above 65%, stocks would be sold and other asset classes purchased until the original 60% target had been restored. • This is obviously a more flexible rule than periodic rebalancing, but in volatile markets it can trigger a great deal of unnecessary buying and selling. Threshold Rebalancing.

  10. This approach is similar to threshold rebalancing, except that when an asset class rises or falls more than the allowed amount, it is rebalanced back to the maximum, not the target, allocation. • Suppose, for example, a portfolio has a 20% target for small-cap stocks, plus or minus five percentage points, but a sudden market rise takes that percentage to 28%. • Stocks would be sold until the small-cap share had been returned to 25%— not the initial 20% allocation. Range Rebalancing

  11. Triggers are based on the expected volatility of the portfolio as a whole. When volatility rises above a certain predetermined threshold, higher-volatility asset classes are sold and lower-volatility asset classes are purchased. So, for example, excessive volatility might lead an investor to sell small-cap stocks— a relatively risky asset class—and buy short-term bonds—a relatively low-volatility asset class. Volatility-Based Rebalancing.

  12. Portfolios are rebalanced to the original target allocations as needed, based on analysis of expected market conditions. This approach is similar to “tactical” asset allocation, which seeks to exploit short-term market trends. Believe markets are not continuously efficient, and securities mispricing at times gives an opportunity for beating market. Practitioners believe that they can beat the market. Combines both fundamental and technical analysis Higher transaction cost Active Rebalancing.

  13. Based on predetermined rules that specify the nature, timing and proportion of change. Contains two portfolios: aggressive and conservative. They differ in their volatility and the type of investments. Economic conditions and the aggressive and conservative portfolios. The prices of the two portfolios FORMULA PLANS

  14. The volatility of the aggressive portfolio depends on the risk tolerance of the investor. The aggressive portfolio can be divided among a number of stocks with high volatilities to overcome any pitfalls in the future expectations of the stock movements. Formula plans provide the highest gains if the stock prices move through a full cycle, a peak and a trough. FORMULA PLANS

  15. Such as rebalancing when the aggressive portfolio moves up or down by 20% Constant dollar value paln

  16. Constant dollar value paln

  17. Such as when the amount invested in each portfolio is equal, then revising the portfolio when the ratio of the aggressive portfolio to the conservative portfolio changes upward or downward from the target value of 1 by 10%. So the first action point will be either at 1.10 or at 0.90. The adjustment is made so the two portfolios should be equal. Constant ratio plan

  18. Constant ratio plan

  19. The actual benefits of rebalancing—and the correct choice of rebalancing strategies depend on many factors, some of them unique to each investor. • Most individual and corporate investors, for example, must pay taxes. Frequent rebalancing could lead to the realization of substantial capital gains, and the taxes on these gains might offset any improvement in post-tax returns. Cost of Rebalancing

  20. Brokerage commissions and other trading costs also need to be taken into account. Cost of rebalancing

  21. Risk bearing ability: investors may have difficulty in expressing their risk-tolerances in terms of portfolio volatility. Investment planning horizon: the Shorter the time frame, the lower the probabilities of achieving expected returns Practical problems in portfolio revision

  22. The Benefits of Rebalancing your Portfolio (video)

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