The key to creating an optimally diversified long-term portfolio is to follow an asset allocation strategy that reflects your risk-return requirements. However, the investment landscape is not static. It is constantly changing with periods of heightened volatility followed by periods of stability. Thus, it is important to have an agile asset allocation strategy. The best way to achieve this agility is through rebalancing.
What is Portfolio Rebalancing?
Over a period of time, a portfolio’s asset allocation might drift from its original weights as some assets outperform others. Due to this, the risk-return profile of the portfolio changes. For example, assume that you are a risk averse investor who has invested 30% of the portfolio in equities and 70% in debt. In a bull year, the value of equities went up such that its weight in your portfolio increased to 60%. Due to higher exposure to equities, your portfolio has now become riskier. In order to reinstate the risk profile of the portfolio, you should now rebalance. Rebalancing can resolve this issue by selling the overweight assets and using the proceeds to buy underweight assets. This ensures that you adhere to your asset allocation strategy and maintain the intended risk-return profile.
Types of Rebalancing
There are three primary ways by which you can rebalance your portfolio. These are discussed below:
Periodic Rebalancing - Periodic, or time-based rebalancing is a simple approach to rebalancing your portfolio. It entails rebalancing your portfolio basis a pre-determined time period. For example, you could decide to rebalance your portfolio monthly, quarterly or annually. The rebalancing activity would be conducted only as per the set frequency irrespective of how much the asset allocation might have drifted in the time between two periods. Thus, even though this strategy is simple to follow, it can sometimes defeat the purpose of rebalancing since the portfolio is sometimes allowed to deviate from the intended allocations for an extended period of time, thereby increasing portfolio risk. The frequency of rebalancing will primarily depend on your risk tolerance and the cost of rebalancing the portfolio. If the cost of rebalancing is high, then you might choose to rebalance less frequently. Again, this could be detrimental to your asset allocation strategy.
Tolerance Band Rebalancing - Tolerance band, or threshold based rebalancing ignores the time period and instead focuses on how much the assets have drifted from their target asset allocation. In this case, you can determine a threshold, for example, 5%, 10% or even 20%. When the portfolio assets drift from beyond these predetermined threshold levels, then rebalancing is triggered. While this seems like a more effective approach to rebalancing it is important to consider the nature of the assets and average volatility before choosing the threshold. If the threshold is too low, then you will end up rebalancing quite frequently. On the other hand, if the threshold is too high, then your portfolio could witness prolonged periods of heightened risk.
Hybrid Rebalancing – A combined or hybrid approach may sometimes be the most optimal way of rebalancing. This would basically entail checking the portfolio at a predetermined frequency for drifts beyond a certain threshold. If on that date the portfolio has drifted beyond the threshold, then rebalancing is triggered.
Deciding on a rebalancing strategy can be challenging for an individual investor. On the one hand, there are the costs of rebalancing and on the other, the risks of not rebalancing. The risks are further amplified when choosing between periodic and threshold rebalancing. In such a scenario, your financial advisor can help you by assessing your risk tolerance and then determining the rebalancing strategy that is best suited for you.
