how rebalancing works
portfolio rebalancing aims to protect investors from exposure to undesirable risks while providing exposure to reward it can also ensure that a portfolio s exposure remains within the portfolio manager s area of expertise there are times when a stock s price performance can vary more dramatically than that of bonds therefore a portfolio s percentage of equity related assets should be assessed as market conditions change if the value of equities in a portfolio causes the allocation in stocks to rise above their preset percentage a rebalancing may be in order that would involve selling some shares of stock to lower the overall percentage of equities in the portfolio investors may also wish to adjust their overall portfolio risk to meet changing financial needs for instance an investor who needs a greater potential for return might increase the allocation in assets that involve higher risk such as equities to improve that potential or if income becomes more important than it was before the allocation of bonds could be increased some investors may mistakenly understand rebalancing to refer to adjusting for an even distribution of assets however a 50 50 stock and bond split is not required a portfolio s target allocation of assets just as easily could be 70 stocks and 30 bonds 40 stocks and 60 bonds or 10 cash 40 stocks and 50 bonds the allocation depends on the goals and needs of an investor while there is no required schedule for rebalancing a portfolio it s recommended that investors examine allocations at least once every year investors don t have to rebalance but generally that s ill advised rebalancing gives investors the opportunity to sell high and buy low taking the gains from high performing investments and reinvesting them in areas that are expected to see notable growth an investment plan where asset allocations and rebalancing are defined can range from a simple idea or strategy created by an individual to a multi page package developed by a portfolio manager an investment plan can help ensure that every investor takes needed actions including rebalancing and avoids inappropriate steps that could affect a portfolio s return negatively types of rebalancingcalendar rebalancing is the most rudimentary rebalancing approach this strategy involves analyzing and adjusting the investment holdings within the portfolio at predetermined times many long term investors rebalance once a year other types of investors with different outlooks and goals may rebalance quarterly or even monthly weekly rebalancing could be overly expensive and unnecessary the ideal frequency of rebalancing must be determined based on an investor s time constraints threshold for transaction costs and allowance for value drift advantages of calendar rebalancing over more responsive methods are that it is less time consuming and costly for the investor since it involves fewer rebalancing occasions and potentially fewer trades however a downside is that it does not call for rebalancing at other dates even if the market moves significantly a more responsive approach to rebalancing focuses on the allowable percentage composition of an asset in a portfolio this is known as a constant mix strategy with bands or corridors every asset class or individual security is given a target weight and a corresponding tolerance range for example an allocation strategy might include the requirement to hold 30 in emerging market equities 30 in domestic blue chips and 40 in government bonds with a corridor of 5 for each asset class therefore emerging market and domestic blue chip holdings can both fluctuate between 25 and 35 at the same time 35 to 45 of the portfolio must be allocated to government bonds when the weight of any one holding moves outside of its allowable band the entire portfolio is rebalanced to reflect the initial target composition the most intensive rebalancing strategy commonly used is constant proportion portfolio insurance cppi is a type of portfolio insurance that allows the investor to set a floor on the dollar value of their portfolio and structure the asset allocation on it the asset classes in cppi are styled as a risky asset such as equities or mutual funds and a conservative asset of either cash cash equivalents or treasury bonds the percentage allocated to each depends on a cushion value defined as the current portfolio value minus some floor value and a multiplier coefficient the greater the multiplier number the more aggressive the rebalancing strategy the outcome of the cppi strategy is somewhat similar to that of buying a synthetic call option that does not use actual option contracts cppi is sometimes referred to as a convex strategy smart beta rebalancing is a periodic rebalancing similar to the regular rebalancing that indexes undergo to adjust to changes in stock value and market capitalization smart beta strategies take a rules based approach to avoid the market inefficiencies that creep into index investing due to the reliance on market capitalization smart beta rebalancing uses additional criteria such as value as defined by performance measures like book value or return on capital to allocate the holdings across a selection of stocks this rules based method of portfolio creation adds a layer of systematic analysis to the investment that simple index investing lacks although smart beta rebalancing is more active than simply using index investing to mimic the overall market it is less active than stock picking one of the key features of smart beta rebalancing is that emotions are taken out of the process depending on how the rules are set up an investor may end up trimming exposure to their top performers and increasing exposure to less stellar performers this runs counter to the old adage of letting your winners run but the periodic rebalancing realizes the profits regularly rather than trying to time market sentiment for maximum profit smart beta can also be used to rebalance across asset classes if the proper parameters are set in this case the risk weighted returns are often used to compare different types of investments and adjust exposure accordingly examples of rebalancingone of the most common areas investors look to rebalance is the allocations within their retirement accounts asset performance impacts the overall value and many investors prefer to invest more aggressively at younger ages and more conservatively as they approach retirement age often the portfolio is at its most conservative once the investor prepares to draw out the funds to supply retirement income so over the years a portfolio may be rebalanced to reflect an increasingly greater allocation in fixed income securities depending on market performance investors may find a large number of assets held within one area for example should the value of stock x increase by 25 while stock y only gained 5 a large amount of the value in the portfolio is tied to stock x 