Rebalancing

Jan 09 2023 | 4 min

Introduction

Previous articles discussed the importance of a long-term investment strategy to achieve investment goals within the risk tolerance of each investor. This entails an investment plan with an asset allocation strategy that diversifies the portfolio across uncorrelated asset classes. The investment portfolio must be managed actively to address market changes and provide optimal risk-adjusted returns that achieve long-term goals within the investor’s risk tolerance.

What is rebalancing

Rebalancing keeps your investment portfolio in line with your investment plan as the value of assets fluctuates over time.

For example, if stocks grow rapidly and the value of the stocks in the portfolio increase from 30% to 50%, the asset allocation must be restored by selling some stocks and using the proceeds to purchase other assets.

Why it is important

Rebalancing enables the portfolio to stick to the investment objectives. 90% of the portfolio risks and returns over time are based on the asset allocation strategy.

Movements in the value of securities are often exaggerated by fleeting investor sentiment rather than underlying fundamentals. Selling securities that have grown sharply in value and buying those that have fallen in price maximizes returns by realizing profits on overvalued securities and investing in undervalued ones that promise more growth.

 Those who remain dispassionate and “buy the dip” benefit when the sentiment passes and the price recovers, avoiding bubbles or manias.

How it is done

The most basic rebalancing strategy is based on defined time intervals—quarterly semi-annually or annually. This approach requires minimal effort as market movements are ignored between the rebalancing intervals which can reduce transaction costs.

Another approach is based on market movements to ensure that no asset category deviates beyond a defined tolerance range (e.g. +/- 10%). This addresses errors in a more timely manner but can incur higher transaction costs.

Regardless of whether rebalancing is based on time or market movements, it is generally prudent to revisit the portfolio at least once or twice a year.

Risks to consider

Not all declines are due to market sentiment. Buying assets that have fallen in value due to genuine underlying fundamentals may reduce returns.

 Depending on the jurisdiction, tax treatments may need to be considered. Some jurisdictions levy a tax on unrealized gains while others treat capital gains on assets that are held for a specified period more favorably.

Another factor is human psychology. A 1985 study of mutual fund performance by Hersh Shefrin and Meir Statman documented the “disposition effect,”[1] where investors tend to ignore timely rebalancing by holding losing stocks too long and selling winning stocks too soon, leading to negative results.

Given the above complexities, investors are advised to work with a well-informed, objective financial advisor to maximize the benefits of rebalancing against the irrationality of markets and the human mind.

[1] CFA Institute - https://www.cfainstitute.org/en/research/cfa-digest/2009/11/what-drives-the-disposition-effect-an-analysis-of-a-long-standing-preference-based-explanation

 

Disclaimer

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