Rebalancing
Suppose you held a large allocation to tech stocks between 1998 and 2000. You, along with most investors, would have been pretty thrilled when the NASDAQ climbed to over 5,000, but some analysts were concerned with the enormous increase of technology stocks.
But for some investors who had an investment policy statement with quarterly shifts in allocation, the impending free-fall from 5,000 back to almost 1,000 by the end of 2002 wasn't a big deal.
Exactly!
These investors sold as the market climbed to bring their technology exposure back in line with their IPS. So they booked gains and didn't suffer traumatic losses.
This illustrates how important __rebalancing__ can be to an investor. Rebalancing is when the portfolio weights are adjusted to more closely align with the strategic asset allocation. In most cases, the IPS will detail the investor's specific rebalancing policy.
That's not it.
That would be a double-up strategy that would have really hurt during the NASDAQ crash.
Not quite.
Buy and hold can be a smart approach, but that's not a shift in allocations.
If higher expected returning assets are generating returns, then what else is also increasing in the account?
This also decreases a significant benefit of strategic asset allocation. What benefit is reduced by a lack of rebalancing?
That's not it.
Rebalancing is a strategic asset decision, so it's not just applied to taxable accounts.
Not quite.
Dividends aren't guaranteed to be increasing, even if the market values are increasing.
But when you really break it down, rebalancing is a contrarian investment approach. Why is rebalancing naturally contrarian?
No.
Liquidity needs should already be held in short-term investments, so that shouldn't be a problem.
Not quite.
If higher returns are generated, then the time-horizon risk is actually reduced.
What's another way to think about this rebalancing range?
That's right!
It's a contrarian approach because it goes against the natural tendency of investors to let growing positions continue to appreciate. So it shouldn't be a surprise that rebalancing takes some serious discipline.
And this disciplined approach to maintaining the strategic asset allocation appears straightforward, but there are lots of little details that must be addressed. For example, when to rebalance, what levels require rebalancing, and where to rebalance the allocations to are all necessary questions to answer.
Nice try, but no.
Rebalancing does allow the continued appreciation of the portfolio, just not excess allocation weights.
Not really.
The strategic asset allocation targets are maintained, so there's no excess risk into lower-valued securities.
You got it!
A 5 percentage point rebalancing range is a no-trade zone because the asset is within that range, so there's no action required. Only when the asset's value passes through a trigger point is action required. A trigger point can be determined by a number of factors like transaction costs, volatility, risk tolerance, and the correlation between asset classes and the balance of the portfolio.
Historically, these ranges have been based on a stock/bond fixed ratio that didn't incorporate portfolio volatility. Other times, proportionate rebalancing bands were used that set the rebalancing band in proportion to the target asset class weight.
That's not it.
If the asset is within the range, then it doesn't need much monitoring.
Not really.
Asset values will fluctuate; that's why the ranges are wide enough to allow these natural movements.
If more rebalancing is required to achieve more precision, then what else increases as a result?
No.
Volatility would technically be limited as the asset ranges are monitored closely.
You got it!
Trading charges are going to increase as the frequency of monitoring increases, so there's a natural trade-off when it comes to how often to check the target ranges.
Then the question becomes what the appropriate trade size and timeline for implementing the rebalancing is. In actual usage, there are several options including rebalancing back to target weights, to the range edge, or halfway between the range-edge trigger point and the target weight.
That would be nice, but that's not it.
The excess asset class returns wouldn't be allowed to really take off because of this precision rebalancing.
To sum it up:
[[summary]]
Why would these investors remain relatively calm?
You can see from the example that market performance can lead to shifts in the asset allocations to move back to the strategic asset allocation weights. But there's more than just market performance. Changes in investor circumstances, revised economic outlook, or tactical shifts can cause the portfolio weights to change and lead to rebalancing.
Overall, though, investors definitely prefer to rebalance due to an increase in price from the assets that are expected to drive returns. And this rebalancing serves a larger purpose than just saving gains.
That's it!
If assets have a higher expected return, then there's a high probability that there's also a lot of risk. So as these asset prices increase, so does concentrated portfolio risk. Think about why portfolio risk will concentrate within the portfolio. As these riskier assets experience increases in value, the positions tend to dominate the portfolio.
Indeed!
Diversification benefits will be reduced as the portfolio positions with excess risk continue to grow and dominate the portfolio's value. That means that rebalancing can serve to reduce risk by aligning asset allocation weights to what the investor originally intended.
This is where various rebalancing strategies can come in. To start, there's __calendar rebalancing__, which (as the name implies) rebalances the portfolio to the target weights based on a specific period of time (monthly, quarterly, annually, etc.).
There's also __percent-range rebalancing__ where the portfolio is rebalanced to thresholds or trigger points, usually specified as a percentage of the portfolio's value. For example, the trigger points might be 30% to 35% of the portfolio's value, which creates a 5 percentage point rebalancing range.
This then brings up some additional questions, like how frequently the percent-range rebalancing should be applied. Really, this depends on the investor because more consistent monitoring actually involves a trade-off.
Risk
Taxes
Dividends
Liquidity
Diversification
Time-horizon management
It doesn't allow for continued gains
It goes against natural investment behavior
It encourages more risk-taking in lower-valued assets
It's a no-trade zone
It requires consistent monitoring
It should be kept as close to the midpoint of the range as possible
Volatility
Trading charges
Excess asset class returns
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They reallocated their tech exposure on the way up
They bought more as the tech sector climbed higher
They remain committed to a buy-and-hold strategy regardless of market performance
