The art of rebalancing
September 24, 2004
Investment success begins with a sound asset allocation plan – one that matches an investor’s financial goals and his or her tolerance for risk.
But I don’t believe it ends there. By analyzing the expected performance of different asset classes, investors can seek to construct portfolios that will – over the long run – yield the highest possible return for a given level of risk.
Rebalancing is the process of making periodic adjustments to an investment portfolio to help ensure that it remains on course with a long-term investment strategy. My primary objective of this article is to provide information on some of the most popular portfolio rebalancing strategies and help you understand how important periodic rebalancing adjustments can be to help ensuring your long-term investment success.
Choice of strategies when rebalancing:
• Periodic rebalancing. Periodic rebalancing requires a portfolio to be reset to its target allocations on a fixed schedule – such as monthly, quarterly or annually. This strategy has the virtue of simplicity, but can require frequent, minor adjustments. It can also be very rigid, and doesn’t allow investors to temporarily overweight asset classes or sectors that are expected to outperform over the shorter term.
• Threshold rebalancing. This strategy requires portfolios to be adjusted if and when a particular asset class deviates from its target allocation by more than a certain amount – such as a specific percentage point. This strategy is more flexible than periodic rebalancing, but in volatile markets it can trigger a great deal of unnecessary buying and selling.
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• Range rebalancing. This approach is similar to threshold rebalancing, except when an asset class rises or falls more than the allowed amount, it is rebalanced back to the maximum, not the target, allocation. When using range rebalancing, investors adjust their portfolios to a maximum deviation amount when they rise or fall more than the allowed amount.
• Volatility-based rebalancing. Volatility-based rebalancing is based on the expected volatility of the portfolio as a whole. When volatility rises above a certain predetermined threshold, higher-volatility asset classes are sold and lower-volatility asset classes are purchased.
• Active rebalancing. This process entails the rebalancing of the portfolio to target allocations based on an analysis of expected market conditions. This approach is similar to “tactical” asset allocation, which seeks to exploit short-term market trends. However, it is more conservative than a market-timing approach, because changes in the portfolio tend to be relatively modest.
When considering rebalancing, it is important to understand the pros and cons. There may be higher monetary costs when rebalancing, such as commissions and tax expenses and as more changes are made to keep the investments on a target, the amount of taxes may increase as well.
I believe the primary goal of rebalancing is to help ensure that your investments adhere to a properly diversified asset allocation strategy. In periods of market volatility – including periods of out performance – rebalancing can help ensure that your investment strategy remains on course. For information, e-mail firstname.lastname@example.org or call 689-8700.
William Creekbaum, MBA, CFP, is senior investment management consultant of SmithBarney, a financial services firm serving Northern Nevada.