What is Portfolio Rebalancing?
Portfolio rebalancing is the process of adjusting the allocation of assets in an investment portfolio to maintain a target asset allocation. Over time, different investments grow at different rates, causing the portfolio to drift from its original structure. Rebalancing realigns the portfolio by selling assets that have become overweight and buying those that are underweight, ensuring that it stays aligned with the intended risk and return profile.
Why Rebalance?
Maintains Target Asset Allocation
A well-constructed portfolio has an intentional balance between asset classes (e.g., stocks, bonds, commodities). Without rebalancing, certain investments may grow too large or too small relative to the rest of the portfolio, leading to unintended risk exposure.
Manages Risk and Return
Portfolio construction involves balancing risk and expected return. When a portfolio drifts from its target allocation, its risk profile changes. Rebalancing keeps the portfolio in line with its intended level of risk and potential reward.
Enhances Cash Management
Dividends, interest, and new deposits are continuously added to a portfolio. Rebalancing ensures that this cash is put to work rather than sitting idle, helping optimize long-term growth.
The Trade-Offs
While rebalancing is an essential tool, there is an optimal balance for how frequently it should be done.
🥳 Rebalancing too frequently...
...can lead to excessive trading costs (both explicit costs like transaction fees and implicit costs like bid-ask spreads) and potential tax implications, particularly capital gains taxes
😴 Rebalancing too infrequently...
...allows the portfolio to drift too far from its target allocation, exposing investors to unintended risks and reducing the benefits of a disciplined investment strategy
The Mechanics of Rebalancing
Rebalancing generally involves selling assets that have performed well and buying those that have underperformed. This systematic approach helps investors stay disciplined, avoiding emotional decision-making that can lead to buying high and selling low. However, selling winners may trigger taxable capital gains, especially in taxable accounts.
Rebalancing and Portfolio Construction Theory
Investment portfolios are built around the relationship between risk and return. Investors seek to optimize their portfolio by maximizing returns while keeping risk at an acceptable level.
Higher-risk assets tend to have greater return potential but also higher volatility.
Lower-risk assets provide stability and income but typically offer lower returns.
Rebalancing ensures that a portfolio remains aligned with its intended risk-reward balance. For example, if stocks significantly outperform bonds over a period, a portfolio originally designed to be 60% stocks and 40% bonds might shift to 75% stocks and 25% bonds.
This means the portfolio is now riskier than intended. Rebalancing would restore the original 60/40 mix, keeping the investor’s risk exposure in check.
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