Rebalancing
Rebalancing is the process of periodically adjusting a portfolio back to its target asset allocation by buying underweighted assets and selling overweighted ones. This risk management strategy can be calendar-based (e.g., quarterly or annually) or threshold-based (when allocations drift beyond set limits).
Exam Tip
Rebalancing maintains TARGET ALLOCATION and controls RISK. Calendar-based (e.g., annually) or threshold-based (e.g., 5% drift). Purpose is risk management, NOT return maximization. New contributions can rebalance tax-efficiently.
What is Portfolio Rebalancing?
Rebalancing is the process of realigning the weightings of assets in a portfolio to maintain the original desired level of asset allocation. Over time, as investments perform differently, the portfolio drifts from its target allocation, potentially increasing or decreasing risk beyond the investor's tolerance.
Why Rebalancing Matters
| Without Rebalancing | With Rebalancing |
|---|---|
| Portfolio drifts from target allocation | Maintains intended risk level |
| Risk profile changes over time | Consistent with investment policy |
| May become overweight in winners | Systematically sells high, buys low |
| Ignores discipline | Enforces investment discipline |
Rebalancing Strategies
| Strategy | How It Works | Pros | Cons |
|---|---|---|---|
| Calendar-Based | Rebalance at fixed intervals (monthly, quarterly, annually) | Simple, predictable | May miss optimal opportunities |
| Threshold-Based | Rebalance when allocation drifts beyond set % (e.g., 5%) | Responsive to market moves | Requires constant monitoring |
| Hybrid (Calendar + Threshold) | Check at intervals AND when thresholds breached | Best of both approaches | More complex to implement |
Calendar-Based Rebalancing
| Frequency | Characteristics |
|---|---|
| Monthly | More frequent trading, higher costs |
| Quarterly | Common for institutional investors |
| Semi-Annually | Moderate approach |
| Annually | Lower costs, optimal for most individual investors |
Threshold-Based Rebalancing
| Threshold Level | Action Triggered |
|---|---|
| Absolute (e.g., 5%) | Rebalance when allocation deviates 5% from target |
| Relative (e.g., 25%) | Rebalance when allocation changes 25% from its target weight |
Example: If target is 60% stocks and threshold is 5%, rebalance when stocks reach 65% or 55%.
Rebalancing Example
| Asset Class | Target | Before Rebalance | After Rebalance |
|---|---|---|---|
| Stocks | 60% | 70% (grew) | 60% |
| Bonds | 30% | 24% (lagged) | 30% |
| Cash | 10% | 6% | 10% |
Tax-Efficient Rebalancing Methods
| Method | Description |
|---|---|
| New contributions | Direct new money to underweighted assets |
| Dividend reinvestment | Reinvest dividends in underweighted classes |
| Tax-advantaged accounts | Rebalance in IRAs/401(k)s to avoid taxable events |
| Tax-loss harvesting | Pair rebalancing with loss realization |
Rebalancing Considerations
| Factor | Impact |
|---|---|
| Transaction costs | Trading fees reduce returns |
| Tax consequences | Selling winners triggers capital gains |
| Market timing | Rebalancing is NOT market timing |
| Risk tolerance | Purpose is risk management, not return maximization |
Exam Alert
Key exam points for Rebalancing:
- Primary purpose: Maintain target asset allocation and RISK LEVEL (not maximize returns)
- Calendar-based: Simple but may miss opportunities; annual rebalancing is common
- Threshold-based: More responsive but requires monitoring; common threshold is 5%
- Systematic approach: Enforces "sell high, buy low" discipline
- Tax efficiency: Use new contributions and tax-advantaged accounts when possible
- Research shows rebalancing can add 0.5% to annual returns while controlling risk
Study This Term In
Related Terms
Asset Allocation
SecuritiesAsset allocation is an investment strategy that divides a portfolio among different asset classes (stocks, bonds, cash) based on an investor's goals, risk tolerance, and time horizon to optimize risk-adjusted returns.
Diversification
GeneralDiversification is an investment strategy that spreads investments across various assets, sectors, or geographic regions to reduce risk without necessarily sacrificing returns.
Systematic Risk (Market Risk)
SecuritiesSystematic risk is the inherent risk that affects the entire market or asset class, which cannot be eliminated through diversification and includes factors like interest rates, inflation, and recessions.