Rebalancing
Rebalancing refers to the process of returning the values of a portfolio's asset allocations to the levels defined by an investment plan. Those levels are intended to match an investor's tolerance for risk and desire for reward.
Over time, asset allocations can change as market performance alters the values of the assets. Rebalancing involves periodically buying or selling the assets in a portfolio to regain and maintain that original, desired level of asset allocation.
Take a portfolio with an original target asset allocation of 50% stocks and 50% bonds. If the stocks' prices rose during a certain period of time, their higher value could increase their allocation proportion within the portfolio to, say, 70%. The investor may then decide to sell some stocks and buy bonds to realign the percentages back to the original target allocation of 50%-50%.
Definition: Rebalancing is the process of adjusting the asset allocation of an investment portfolio to the levels specified in the investment plan. These levels are designed to match the investor's risk tolerance and return desires. Over time, market performance changes the value of assets, causing asset allocation to shift. Rebalancing involves periodically buying or selling assets in the portfolio to restore and maintain the original expected asset allocation levels.
Origin: The concept of rebalancing originated from Modern Portfolio Theory (MPT), introduced by Harry Markowitz in the 1950s. Markowitz's theory emphasized reducing risk through diversification and highlighted the importance of asset allocation. Over time, investors and financial institutions recognized the importance of regular rebalancing to ensure that the risk and return characteristics of a portfolio remain within the expected range.
Categories and Characteristics: Rebalancing can be categorized into periodic rebalancing and conditional rebalancing. Periodic rebalancing occurs at predetermined intervals (e.g., quarterly or annually), while conditional rebalancing occurs when asset allocation deviates from the target by a certain percentage. The advantage of periodic rebalancing is its simplicity, but it may overlook short-term market fluctuations. Conditional rebalancing is more flexible but requires more frequent monitoring and adjustments.
Specific Cases: Case 1: Suppose an investor's target asset allocation is 60% stocks and 40% bonds. Over a year, the stock market performs well, increasing the stock proportion to 70%. To restore the original allocation, the investor sells some stocks and buys bonds, adjusting the ratio back to 60%-40%. Case 2: Another investor's target asset allocation is 50% stocks, 30% bonds, and 20% cash. During a volatile year, the stock proportion drops to 40%, bonds rise to 35%, and cash increases to 25%. The investor sells some cash and bonds to buy stocks, restoring the ratio to 50%-30%-20%.
Common Questions: 1. How should the frequency of rebalancing be determined? The frequency of rebalancing depends on the investor's risk tolerance and market volatility. Generally, rebalancing quarterly or annually is common practice. 2. Does rebalancing increase transaction costs? Yes, rebalancing can increase transaction costs, especially with frequent rebalancing. Therefore, investors need to balance the risk control benefits of rebalancing with the associated transaction costs.
