What is Rebalacing
In Portfolio Allocation and Portfolio diversification we saw how it is important to maintain a low cost diversified mutual fund portfolio at right risk level to be able to stick through market volatility .
Let’s say based on your risk tolerance best investment portfolio allocation has a original allocation of 60% in stocks and 40% in bonds. After one year, the value of the stock portion has increased by 10% and the bond portion has decreased by 5%. This means the portfolio is now allocated at 65% in stocks and 35% in bonds, which is no longer in line with the your desired allocation. To bring the portfolio back to its original allocation, you could sell some of the appreciated stocks and use the proceeds to buy more bonds.
This process of adjusting the asset allocation is called rebalancing.
By rebalancing, the investor is able to maintain a diversified portfolio that is aligned with their risk tolerance and long-term goals. It also helps to manage risk by selling off assets that have become overvalued and buying those that have become undervalued.
Rebalacing Benefits
One advantage of rebalancing is the ability to implement a buy low, sell high strategy.
For example, if the value of equities in a portfolio decreases, an investor may decide to sell some of their bond holdings and buy more equities at a lower price (Buy Low). This allows the investor to take advantage of market fluctuations and potentially improve the performance of their portfolio. The long-term risk orientation, as determined by the original allocation (say 60:40) of assets in the portfolio, serves as the anchor for these buy low, sell high decisions.
Top 5 benefits of Rebalancing are
- Maintaining risk: Rebalancing helps to maintain an investor’s desired level of risk by adjusting the asset allocation of their portfolio.
- Capturing gains: Rebalancing can help investors capture gains by selling appreciated assets and reallocating the proceeds to underperforming ones.
- Maintaining diversification: By periodically adjusting the allocation of assets, rebalancing can help investors ensure their portfolio stays diversified and not overly concentrated in certain assets or sectors.
- Managing risk: Rebalancing can help manage risk by preventing a portfolio from becoming too heavily weighted in any one asset class or sector.
- Providing a behavioural anchor: Rebalancing can help investors stick to their long-term goals by providing a strong behavioural anchor for investment decisions.
Downsides
Rebalancing is a strategy that aims to manage risk in a portfolio by periodically adjusting the mix of investments. It prioritises risk management over high final terminal wealth. Let’s take a bull market scenario where market continually rises. Your original allocation is 60:40 and after a year it is 65:35. A Rebalance is done to 60:40. Equity runs up for year 2. Now a smaller portion i.e 60% is participating in growth instead of 65% hence reducing your profits.
Similarly in a bear market when equity continues to go down the reverse happens. Your original allocation is 60:40 and after a year it is 55:45. A Rebalance is done to 60:40. Equity fall continues for year 2. Now a larger portion i.e 60% is participating in the losses instead of 55% hence increasing your losses.
There is a timing risk involved in Rebalancing. There are other downsides to Rebalancing..
Key downsides
1. Rebalancing involves timing risk, or the risk of making decisions about when to buy and sell assets that end up being poorly timed. For example, if an investor rebalances their portfolio and sells an asset just before it goes up in value, they could miss out on potential gains.
2. Costs of buying and selling assets. Every time an investor buys or sells an asset, they may incur transaction costs such as broker fees or spreads. These costs can add up over time and reduce the overall returns of the portfolio.
3. Taxes : Rebalancing a taxable portfolio can also generate tax costs if the sale of assets generates capital gains. This can further reduce the overall returns of the portfolio.
4. Overall, while rebalancing can be a useful risk management strategy, it may not always outperform a buy and hold strategy, especially in markets that are consistently going up or down. It requires getting three things right – minimizing transaction costs, minimizing taxes, and timing the mean reversion correctly – to outperform a buy and hold strategy.
Key Considerations
Investors should thus consider the following aspects and build into their rebalancing strategy
- Cost: Investors should consider the costs of rebalancing, including transaction costs, tax costs, and timing risk, and factor these into their rebalancing strategy.
- Benefits: Investors should also consider the potential benefits of rebalancing, including risk management, capturing gains, and maintaining diversification, and weigh these against the costs.
- Rebalancing strategy: Investors should decide on a rebalancing strategy that aligns with their investment goals and risk tolerance. This may involve rebalancing the portfolio on a fixed schedule (such as annually or quarterly), or using threshold levels to trigger rebalancing (such as rebalancing when an asset class deviates from its target allocation by a certain percentage).
- Tax efficiency: For taxable portfolios, investors can use tax-efficient strategies such as tax-loss harvesting to minimize the tax costs of rebalancing. This can involve selling losing investments to offset gains and reduce the overall tax bill..
Best Practices
1. Establish clear rebalancing rules and stick to them. This will help to ensure that you are disciplined in your approach and avoid making ad-hoc rebalancing decisions.
2. Consider the trade-off between rebalancing frequency and transaction costs. Rebalancing more frequently can result in higher trading costs, which can eat into your returns.
3. Don’t rebalance too frequently. While it’s important to maintain your target asset allocation, it’s also important to allow your investments time to grow. Rebalancing too frequently can result in unnecessary tax implications and transaction costs.
4. Use a systematic approach to rebalancing. This can help to take the emotion out of the process and ensure that you are making decisions based on your established rules rather than on market fluctuations.
5. Seek professional advice: Investors may also want to seek the advice of GrowSuperRich team or professional portfolio manager to help develop a rebalancing strategy that is appropriate for their individual circumstances.
Summary
- Rebalancing is the process of adjusting the allocation of assets in a portfolio to align with an investor’s long-term risk tolerance and investment goals.
- Rebalancing can help to implement a buy low, sell high strategy by selling appreciated assets and buying undervalued ones. It can also help to maintain risk, capture gains, and maintain diversification in a portfolio.
- Rebalancing involves timing risk, transaction costs, and tax costs, which may reduce the overall returns of the portfolio.
Investors should consider the costs and benefits of rebalancing and choose a strategy that aligns with their individual circumstances and investment goals.
