Rebalancing is the process of buying and selling positions in your portfolio to get back to the desired asset allocation.
The necessity to rebalance is a consequence of varying levels of performance between asset classes.
For example, assuming equities were to grow by 10% per year vs bonds 5%, a portfolio consisting of 50% equities and 50% bonds (‘50/50’) would ‘drift’ to a 75/25 allocation over a 25-year period – it would therefore gradually become higher risk (as a higher equity content translates to increased volatility) – rebalancing is crucial to bring it back in line with the agreed risk mandate.
Buy low/sell high
Rebalancing is not only essential to counter ‘portfolio drift’ and a change in risk profile, but it can also enhance portfolio returns.
That’s because it provides an automatic ‘buy low, sell high’ strategy – taking profits on those asset classes and geographies that have outperformed for a period and recycling the proceeds into those that have lagged.
This plays into the cyclical nature of financial markets whereby yesterday’s top performers are rarely tomorrow’s.
‘Smart rebalancing’
However, excessive rebalancing has its downsides too:
- Assets can outperform for long periods (e.g. US stocks currently) – trimming these too soon and/or too frequently, reduces your exposure to said outperformance, and
- This will also incur excessive trading costs which, like investment returns, compound over time.
The optimal rebalancing approach is to capture a proportion of the performance of the outperforming assets, while at the same time mitigating the increased risk of moving too far from the portfolio’s target asset allocation.
To that end, there are a couple of approaches here.
Calendar-based rebalancing
The most common and simplest approach is calendar rebalancing, e.g. monthly, quarterly or yearly, whereby portfolios are rebalanced back to their target allocation at a pre-determined time interval, regardless of market conditions.
However, we believe this is sub-optimal – it reduces the ability of investors to capture upside performance and also increases trading costs, by rebalancing too frequently.
Tolerance-based rebalancing
Instead, we advocate a ‘tolerance-based’ approach, whereby portfolios are brought back to target once the weighting to equities or fixed income as a whole increases or decreases by a certain threshold, most commonly 10%.
This provides a good compromise between:
- ‘Letting the portfolio run’ and having significant exposure to outperforming assets,
- But without taking on excessive risk (relative to the agreed mandate), and
- Keeping trading costs low.
Please let me know if you’d like to know more.
Disclaimers: When investing, your capital is at risk. The value of your investment (and any income from them) can go down as well as up, and you may get back less than you invested, particularly where investing for a short timeframe (we normally recommend a horizon of at least 5 years). Neither simulated nor actual past performance is a reliable indicator of future performance. Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances. This blog is for general information only and does not constitute advice. The information is aimed at retail clients only. Since I don’t know your specific situation, none of this information should be construed as tax or financial advice. It is not an offer to purchase or sell any particular asset and it does not contain all the information which an investor may require in order to make an investment decision. Although endeavours have been made to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. We cannot accept responsibility for any loss as a result of acts or omissions taken in respect of any articles.
