Portfolio

rebalancing
Week 11
Rebalancing
• Rebalancing a portfolio means adjusting the weightings of the
different asset classes in your investment portfolio by buying or selling
assets.

• Over time, different investments will grow at different rates, causing

your asset mix to drift away from your intended target allocation.

• Regular monitoring and periodic rebalancing bring your portfolio back

in line, ensuring it doesn’t become too risky or too conservative for
your needs​
Rebalancing
• The primary purpose of rebalancing is risk management – keeping
your portfolio’s risk level aligned with what you’re comfortable with
and what’s needed to reach your goals.

• Over time, if you never rebalance, your portfolio could become

significantly skewed​.

• Rebalancing ensures your portfolio’s allocation stays in line with your

objectives, preventing it from carrying more risk than appropriate for
your risk tolerance or from straying from your growth requirements​.
Rebalancing
Original (target) portfolio allocation is:
Stocks – 60% Bonds – 30% ETFs – 10%
After 1 year, the different asset classes perform differently:
• Stocks grow 20%
• Bonds grow 2%
• ETFs grow 10%
Assume you started with a $10,000 portfolio.
Rebalancing
Asset Class Starting Value Return New Value
Stocks $6,000 20% $6,000 × 1.20 = $7,200
Bonds $3,000 2% $3,000 × 1.02 = $3,060
ETFs $1,000 10% $1,000 × 1.10 = $1,100
Total $10,000 $11,360

Asset Class New Value New Weight Target Weight Difference

Stocks $7,200 63.4% 60% +3.4%
Bonds $3,060 26.9% 30% -3.1%
ETFs $1,100 9.7% 10% -0.3%
How often should you
rebalance?
Rebalancing frequency can vary based on personal factors like age, time
horizon, and risk tolerance​.

Finding a balance: rebalance too often and you incur needless

transaction costs or taxes (and potentially miss out on momentum from
winning assets);

rebalance too rarely and your portfolio can drift to an allocation that no
longer suits your objectives​
Rebalancing strategies
Two popular approaches include calendar-based and threshold-based
(tolerance band) strategies:
1. Calendar-Based Rebalancing:
rebalance at regular intervals (e.g. every quarter, semi-annually, or
annually). This method is straightforward and ensures you check in
periodically.
Reviewing too frequently (say, weekly) is usually not advisable.
Rebalancing strategies
2. Threshold-Based Rebalancing:
rebalance only when your allocation has deviated by more than a set
tolerance band (e.g. ±5%) from your target.
For example, if your target is 60% stocks / 40% bonds, you might rebalance only
if stocks exceed 65% or fall below 55% of the portfolio​.
This approach is more dynamic, responding to actual market
movements rather than the calendar.

3. Hybrid Approach:
monitor your portfolio frequently (e.g. quarterly or monthly checks) but
only rebalance when the drift exceeds your chosen threshold​.
Steps to Rebalance Your Portfolio:
1. Review your target allocation:
Start with clarity on your intended asset mix.
This is the percentage of your portfolio you want in each category.
Your target allocation should reflect your risk tolerance, return needs, and time
horizon​.

2. Assess Your Current Allocation:

Calculate what percentage of your portfolio’s value is in stocks, in bonds, and in
other assets (like cash or alternative investments).
This step gives you a clear picture of how far off each portion is from the target.
Steps to Rebalance Your Portfolio:
3. Identify Deviations from Target:
Compare the current percentages to your target percentages for each
asset class. Identify which asset classes are overweight (above their
target) and which are underweight (below their target).

4. Develop a Rebalancing Action Plan:

Decide how you will get back to target weights.
The classic way is to sell some of the overweight assets and buy more
of the underweight assets with those proceeds​.
Steps to Rebalance Your Portfolio
• Try to use cash flows:
If you regularly add new investments (e.g. monthly contributions) or have
dividends and interest coming in, you can direct those new funds into
underweight assets.
This way you rebalance by addition instead of selling, which can minimize
taxes and fees​.

• Be mindful of trading costs:

avoid over-trading – every transaction can have bid/ask spread costs or
potential fees. Plan to execute only the necessary trades to minimize cost.
Steps to Rebalance Your Portfolio
5. Execute the Rebalancing Trades:
Execute the sell orders and buy orders needed to bring the portfolio
toward the target mix.
After executing, double-check that your new allocation is close to your
targets.
You don’t have to hit the exact percentages; being within a small range
(and within your tolerance bands) is typically fine.
Steps to Rebalance Your Portfolio
6. Monitor and Repeat: Rebalancing is not a one-time event—it’s an
ongoing maintenance task.
After rebalancing, continue to monitor your portfolio’s allocation over
time and repeat this process at your next interval or whenever a trigger
condition is met​.

By following these steps, you effectively “sell high and buy low” in your
portfolio – trimming assets that have become relatively expensive and
boosting those that are relatively cheap.
Tax and Transaction Fee
Considerations
• One of the most important aspects of rebalancing is managing the
costs, especially taxes and transaction fees.
• Unplanned taxes or high fees can eat into your investment gains.

One way to rebalance without incurring taxes on capital gains is to use

cash inflows to adjust allocations.
• Direct new contributions/dividends to underweight assets instead of
selling overweight ones.
Adjusting to Life Changes and Goals
Your target allocation itself may evolve over time – and rebalancing is a
good opportunity to implement those changes.

Rebalancing sessions are when you would execute such shifts.

Instead of restoring the old allocation, you’ll set a new target and
rebalance toward that.
Always ensure your portfolio’s balance reflects your current goals.
Maintaining Diversification
• Rebalancing inherently helps you maintain diversification across asset
classes (stocks, bonds, etc.).
• It can also be applied within asset classes to manage risk –
for example, if one stock or one sector in your equity portfolio becomes
too large a portion, you might rebalance within stocks to trim that
position. A well-diversified portfolio spreads risk, and rebalancing
prevents any one holding or asset category from dominating over time​.
Discipline Over Emotion
• Rebalancing imposes a rule-based approach that helps take emotion
out of investing.
• It can be psychologically tough – rebalancing often means selling your
recent winners and buying assets that have underperformed.
• This feels counterintuitive to many (“Why sell what’s doing well? Why
buy what’s down?”).
• But that’s exactly how you buy low and sell high.
Discipline Over Emotion
• Rebalancing is not about maximizing return in the short run; it may
even reduce returns in roaring bull markets since you trim winners.

• The goal of rebalancing is to manage risk, not to chase performance

or time the market​.

• Rebalancing protects you from outsized losses if markets reverse and

helps ensure you’ll achieve the return needed for your goals.
Common Rebalancing Mistakes
to Avoid
1. Neglecting to rebalance (letting your portfolio drift):
Failing to rebalance effectively means your risk profile is uncontrolled.
For example, not rebalancing a 60/40 portfolio during a stock bull
market could leave you 80/20 or 90/10, far riskier than intended.
Always monitor your portfolio and take steps to rebalance it as needed​.

2. Rebalancing too frequently or by too small margins:

On the flip side, some investors overdo it – responding to every market
movement.
Rebalancing too often can lead to excessive trading costs and tax bills.
Monitoring
A portfolio manager should track everything affecting the client’s
portfolio.
We can categorize most items that need to be monitored in one of
three ways:
1. Investor circumstances, including wealth and constraints.
2. Market and economic changes.
3. 3. The portfolio itself.
Monitoring Changes in Investor Circumstances and
Constraints

• Periodic client meetings are an ideal time to ask whether needs,

circumstances, or objectives have changed. If they have, the manager
may need to revise the IPS and bring the portfolio into line with the
revisions.
• In the field of private wealth management, reviews are usually
semiannual or quarterly.
• Changes in investor circumstances and wealth, liquidity requirements,
time horizons, legal and regulatoryfactors, and unique circumstances
all need to be monitored
Monitoring Changes in Investor
Circumstances and Constraints
• Changes in circumstances and wealth often affect a client’s
investment plans.
• For private wealth clients, events such as changes in employment,
marital status, and the birth of children may affect income,
expenditures, risk exposures, and risk preferences.
• Each such change may affect the client’s income, expected retirement
income, and perhaps risk preferences.
Changing Liquidity Requirements
• A liquidity requirement is a need for cash in excess of new contributions
or savings as a consequence of some event, either anticipated or
unanticipated.
• Individual clients experience changes in liquidity requirements as a
result of a variety of events, including unemployment, illness, court
judgments, retirement, divorce, the death of a spouse, or the building
or purchase of a home.
• Changes in liquidity requirements occur for a variety of reasons for
institutional clients, such as the payment of claims by insurers or of
retirement benefits by defined-benefit (DB) pension plans, or the
funding of a capital project by a foundation or endowment.
Changing Time Horizons
Individuals age and pension funds mature.
Reducing investment risk is generally advisable as an individual moves
through the life cycle and his time horizon shortens; bonds become
increasingly suitable investments as this process occurs.

Many private wealth clients have multistage time horizons. For

example, a working person typically faces an accumulation stage up to
retirement in. Accumulating funds for a child’s higher education can
create one or more stages before retirement
Changes in Laws and Regulations
• Laws and regulations create the environment in which the investor
can lawfully operate, and the portfolio manager must monitor them
to ensure compliance and understand how they affect the scope of
the advisor’s responsibility and discretion in managing client
portfolios.
Monitoring Market and Economic
Changes
• In addition to changes in individual client circumstances, the
economic and financial markets contexts of investments also require
monitoring. Those contexts are not static. The economy moves
through phases of expansion and contraction, each with some unique
characteristics.
• A portfolio manager’s monitoring of market and economic conditions
should be broad and inclusive. Changes in asset risk attributes, market
cycles, central bank policy, and the yield curve and inflation are
among the factors that need to be monitored.
Changes in Asset Risk Attributes
• The historical record reflects that underlying mean return, volatility,
and correlations of asset classes sometimes meaningfully change.
• An asset allocation that once promised to satisfy an investor’s
investment objectives may no longer do so after such a shift.
• Monitoring changes in asset risk attributes is thus essential.
Market Cycles
• Investors may make tactical adjustments to asset allocations or adjust
individual securities holdings depending on market cycle.

• Central banks have power in the capital markets through the

influence of their monetary and interest rate decisions on liquidity
and interest rates.
• Backtest Portfolio Asset Allocation