Why is it so important?
Every investment plan created for each investment portfolio has carefully assigned, original asset allocation values. These values are created and assigned based on the particular investor’s risk and reward profile. In line with the assets’ market performance and subsequent changes in their respective values, their allocation levels will also change within the portfolio over time.
When those altered asset allocations are reset back to their original values again, the process is called rebalancing an investment portfolio. Rebalancing is an essential part of portfolio management because the process keeps an investment portfolio in sync with the investor’s original investment plan and their risk and reward profiles.
What is the optimal frequency for rebalancing an investment portfolio?
Once a year is the general recommendation, but it is not a universally optimal frequency for rebalancing investment portfolios. The optimal frequency is highly variable as it depends on several factors such as the investor’s:
- Investment portfolio type
- Time restrictions
- Maximum limits for transaction expenses
- Maximum allowance for value drift from the original levels
There are several different types of rebalance strategies and some do not follow any prefixed frequency standards. They are planned and implemented based on the factors mentioned above, which will also be discussed later.
What are the benefits of rebalancing?
The benefits can be underlined as follows:
- Strategic rebalancing keeps assets from drifting too far away from the investor’s intended investment plan.
- A rebalance lowers the chances of investment risks that go beyond the investor’s risk tolerance profile.
- It keeps the investment plan relevant by factoring in each asset’s present market value and adjusting accordingly.
- It helps investors regain control of their assets in the way originally intended.
- A rebalance reveals opportunities to buy and/or sell assets for better immediate and/or future returns from the portfolio.
How does this help manage risk in an investment portfolio?
An investment plan is always designed around the investor’s risk tolerance levels and reward expectations. Therefore, the original asset allocation values defined in the investment plan are specifically assigned to not let the investment go beyond the investor’s risk tolerance threshold at any point. Periodic or responsive rebalancing will prevent assets in an investment portfolio from drifting too far away from the investor’s original investment plan. This in turn makes risk management much easier for that investment portfolios after a rebalance.
Rebalancing lowers investment risks and helps in keeping investment portfolios consistently profitable down the line as well. Timely rebalances also keep investment plans relevant by factoring in present market changes to asset values and making changes in the portfolio’s asset composition accordingly to boost performance.
What are the best practices?
The best practice or strategy will vary based on factors mentioned previously. However, the following two are the most used rebalancing strategy types.
Calendar Rebalancing – Periodic rebalancing where the portfolio will be rebalanced quarterly, biannually, or annually, based on the portfolio’s requirements. Short term investment portfolios may also be rebalanced monthly at times. Long term portfolios are generally rebalanced annually or biannually. Calendar rebalancing strategies are often less expensive.
Constant-Mix Rebalancing – Instead of periodic rebalancing in a fixed frequency, the portfolio is rebalanced reactively. Each asset class in the investment portfolio’s composition is assigned an expected/target percentage, as well as a minimum and maximum allowance for percentage shifts. If even one asset class exceeds the allowed tolerance range, all assets in the investment portfolio will be immediately rebalanced.
In addition, more complex strategies like smart beta rebalancing and constant proportion portfolio insurance (CPPI) can be implemented as well. In the end, the optimal rebalancing practice is always the one that best suits the portfolio’s investment plan.
