When you create an investment portfolio, your risk profile and your financial goals determine the asset allocation within your portfolio – basically, the stock/bond mix. Over time, the performance gap of each asset class can create an imbalance with respect to the initial allocation. Rebalancing will therefore be necessary.
Rebalancing consists of realigning the weightings of an asset portfolio to bring it back to its target allocation. For example, imagine that you open a portfolio whose target allocation is half stocks, half bonds. If stocks perform well over a period of time, the stock weighting in the portfolio may mechanically increase to 70%, creating an imbalance. You could then decide to sell stocks and buy bonds to bring the portfolio back to the initial 50/50 target allocation: this is called rebalancing.
First, portfolio rebalancing helps maintain your portfolio allocation at the level of risk you are willing to bear as an investor. It is therefore above all a risk management strategy within an investment portfolio. Besides, by selling what has gone up and buying what has gone down, rebalancing can potentially increase the overall return of your portfolio.
Rebalancing can be implemented by transferring assets, that is, selling investments from an overweight asset class and using the cash to buy investments from an underweight class. But it can also be done by injecting new money into an underweighted class or by making withdrawals from an overweighted class.
On the question of the frequency of rebalancing, several approaches are possible: for example, one can rebalance at regular intervals or do it when a weighting exceeds a certain threshold defined as “unacceptable”. The advantage of the first approach is its simplicity and cost; the second is more sensitive to market fluctuations but can be expensive in the event of strong variations.
Constant-mix strategy aims at maintaining a desired mix of assets, regardless of the amount of wealth you have, as described above. On the contrary, dynamic asset allocation is a portfolio management strategy that frequently adjusts the mix of asset classes to suit market conditions. Both strategies may require rebalancing: the first to maintain the target mix, the second to adjust the mix to the market conditions or to a specific investment objective.
This is the case in the context of retirement planning where it is appropriate to take a high risk when the investment horizon is still long and to reduce the risk when approaching retirement. In this context, rebalancing can be used to adjust the weighting of your portfolio over time. This reduces the probability of a sharp drop when the capital saved can be withdrawn to generate an annuity.
At easyvest, we distinguish 10 risk profiles and continuously monitor the actual risk level of each client's portfolio. We rebalance a portfolio as soon as its effective risk deviates too much – around 4% in our model – from the target level set with the client. Rebalancing is therefore not done daily in order to minimize the tax friction arising from transactions, to let assets deviate sufficiently before materializing a gain, or to take advantage of a market decline. We also rebalance the portfolios with each cash contribution or withdrawal, for example by selling the asset that has appreciated the most. Finally, when the plan allocation is dynamic over time, we control the portfolio allocation and adapt it automatically as defined in the investment plan.