Rebalancing is the process of periodically realigning a portfolio to its risk profile when it deviates from its equilibrium.
Consider an investor who has a portfolio that initially consists of 50% of equities and 50% of bonds. Over time, it is expected that equities will grow more than bonds. It is therefore likely that at some point the portfolio will hold 60% of equities and 40% of bonds. Our investor is thus exposed to a risk superior to the risk he is willing to accept, as equities are riskier than bonds.
To realign a portfolio to a target risk level, one rebalance it, meaning one sells the surplus of stocks and, with the cash generated by the sale, buy bonds to return to the 50%-50% balance. This implies that the investor who rebalances actually sells holdings with the highest prices to increase its holdings with the lowest prices. Buy low and sell high is a basic principle to grow one's wealth.
Last updated on 22/12/2015