Portfolio Rebalancing

When investors construct their portfolio, it is vital they also develop a suitable rebalancing strategy.  Rebalancing refers to adjusting the current allocations of the investments in a portfolio.

When the current asset allocations diverge from the target asset allocations, it may lead to additional portfolio volatility.  This can be due to a variety of reasons including macroeconomic factors such as rising interest rates, global factors such as geopolitical instability, and/or more specific asset class or company specific risks.  That is why the goal of rebalancing is to maintain the portfolio allocations of your investments commensurate with your level of risk tolerance.  Portfolio rebalancing is not foremost concerned about maximizing returns.

How might an investor implement a rebalancing strategy?  A common approach is to first identify the target percentage allocations based on asset classes for your investment portfolio.  Once these target allocations have been determined, an investor will set a desired ‘tolerance band’ prior to implementing any reallocation changes.  For example, a typical investor with a risk tolerance of 60% equity, 40% fixed income portfolio allocation, might allow for a 5% threshold change for each asset class prior to rebalancing their portfolio.  That is, the portfolio will require rebalancing as the allocation ratio changes to 65%-35% or 55%-45%.  Each investor should adopt a ‘tolerance band strategy’ that is consistent with their personal goals and commensurate with their risk level.

Once an investor has defined his tolerance bands, the next step is to regularly monitor the investment holdings allocations to remain consistent with risk tolerance.  An effective method is to utilize a periodic ‘calendar rebalancing’ schedule.   Calendar rebalancing refers to periodically adjusting the current portfolio allocations back to their target goals, usually done on a semi-annual or annual basis.  Investors will review their portfolio on this calendar schedule, identifying the current allocations to targeted goals, and then identify and make necessary changes to rebalance.  When using the calendar rebalancing method, it is most important to set a schedule that works best for you.  Setting and sticking to a disciplined rebalancing schedule will help keep your allocations in line with your risk tolerance and long-term goals.

It is important to note, rebalancing your portfolio will include associated costs. These include:

Potential Taxes: selling appreciated assets will result in taxes on capital gains. As possible, make allocation adjustments with consideration of taxable versus non-taxable accounts.

Transaction costs: these include brokerage commissions and fees associated with the buy/sale activity to reallocate back to targeted goals.

Labor costs: if using professional services, it will take time and effort for an investment manager to calculate the rebalancing amount and then implement changes, so expect their associated fees for this service.

The benefits of portfolio rebalancing are many.  Focusing on this important concept of portfolio management helps to prevent overly concentrated portfolios, reduces overall portfolio risk, adds discipline to the management process and helps avoid emotional decision-making.  Proper rebalancing is a cornerstone of good portfolio management, and is an important portfolio management task all investors should regularly perform.  Investment Account Manager 3 Individual provides the tools investors need to define and rebalance as necessary investment allocation goals.