Rebalancing

What is Rebalancing?

Rebalancing is the process of adjusting the asset allocation of an investment portfolio to maintain a desired level of risk and return. This involves periodically buying and selling assets to ensure that the portfolio aligns with the investor's original or updated investment strategy and risk tolerance.

Importance of Rebalancing

• Risk Management: Over time, certain assets in a portfolio may perform better than others, causing the portfolio to drift away from its target allocation. This drift can lead to increased risk exposure if higher-risk assets dominate the portfolio. Rebalancing helps mitigate this risk by restoring the original asset allocation.
• Alignment with Investment Goals: Consistent rebalancing keeps the portfolio in sync with the investor's goals and risk tolerance. As market conditions change, so do the values of different asset classes, necessitating adjustments to maintain intended investment strategies.
• Locking in Profits: By selling portions of assets that have appreciated significantly, investors can lock in profits and reinvest in underperforming assets that may have greater growth potential, effectively buying low and selling high.

How Rebalancing Works?

Rebalancing typically involves two main approaches:

1. Time-Based Rebalancing: This method involves reviewing and adjusting the portfolio at predetermined intervals, such as quarterly or annually. For example, if an investor initially allocates 60% to stocks and 40% to bonds, they would check their portfolio every three months and make adjustments back to this allocation if it drifts significantly.
2. Percentage-of-Portfolio Rebalancing: In this approach, rebalancing occurs when an asset class deviates from its target allocation by a specified percentage (e.g., 5%). For instance, if stocks are supposed to represent 70% of a portfolio but grow to 75%, the investor would sell enough stock to bring it back down to 70%.

Steps for Effective Rebalancing

1. Determine Target Allocation: Establish a clear target allocation for different asset classes based on your risk tolerance and investment objectives (e.g., 60% equities, 40% bonds).
2. Monitor Current Allocation: Regularly assess your portfolio's current asset mix against your target allocation.
3. Calculate Adjustments Needed: If your current allocation deviates from your target, calculate how much of each asset needs to be bought or sold to restore balance.
4. Execute Trades: Buy or sell assets as necessary to return to your desired allocation while considering transaction costs and tax implications.
5. Review Regularly: Set a schedule for regular reviews (e.g., annually) or establish thresholds for automatic rebalancing based on percentage deviations.

Benefits of Rebalancing

• Improved Risk-Adjusted Returns: By maintaining a consistent asset allocation aligned with risk tolerance, investors can potentially enhance their long-term returns while managing volatility.
  Adaptability: As financial goals evolve or market conditions change, rebalancing allows investors to adjust their portfolios accordingly.