Portfolio rebalancing strategies – All you need to know

Portfolio rebalancing strategies  – All you need to know

Portfolio rebalancing strategies are useful for you to maintain asset weights at the desired levels.

Which needs to be done every now and then when there is an asset weight % change in your asset allocation strategy.

What is rebalancing?…

Portfolio rebalancing strategies

You already know that to reduce the volatility, investing in multiple assets is a good way of investing your hard-earned money.

In addition, there are several asset allocation strategies to choose from and invest in those strategies.

But the story will not end with asset allocation.

And periodic portfolio rebalancing must be done in order to protect the wealth created and also to generate a risk-adjusted return on investment.

What is portfolio rebalancing?…

While doing asset allocaton for the investor.

% weights will be decided to each of the asset class to invest based on risk profile, age, time horizon, etc.

And portfolio investment means investing in more than one asset class.

But over a period of time, the asset weights will increase or decrease due to the different return on investments from different assets.

In addition, to gain from these weight changes in asset classes, rebalancing of the portfolio will be done.

So that the asset weights will be back to the original values, which were decided at the time of asset allocation.

And this process of brining back the asset weights to the original is called portfolio rebalancing.

For example, you have decided to invest 50% in stocks and 50% in fixed income.

In addition, the expected returns from stocks and fixed income are 15% and 7%, respectively.

In addition, assume that you have invested a total of one lakh in the above portfolio.

Moreover, the equity portion will become Rs. 57,500, and the fixed income portion will become Rs. 53,500 after one year.

And the portfolio value after one year is Rs. 1,11,000.

Moreover, the new weights for equity and fixed income will be 57,500/111000 and 53500/111000.

I.e., equity 52.27% and fixed income 48.20%.

But the original weights at the beginning of investment started are 50% equity and 50% fixed income.

Now, in order to bring back the weights to their original values, some portion of equity will be sold and will be invested in fixed income.

key take aways of rebalancing

How rebalancing works?…

Portfolio rebalancing aims to protect investors from undesirable risks.

And at the same time aims to take exposure to the rewarding ones.

In addition, rebalancing ensures that portfolios remain within the range of portfolio managers expertise.

Sometimes, the prices of stocks will rise rapidly.

And a common investor and when it comes to portfolio managers, they cannot predict 100%; they also do not know when the stock prices stop rising.

Now, to cater to such dilemmas and to protect the wealth created from stock rallies, a portfolio rebalancing tool will be used.

When we are not sure about market movements up and down and when we cannot control our emotions.

A simple mathematical tool will do that work for us.

And portfolio rebalancing is such a tool which will not affect emotions, market fundamentals, technicals, etc.

If you apply a simple formula, it will tell you which asset needed to be sold and which one to be bought.

However, knowing your risk tolerance is always important before selecting the asset allocation strategy and percentage of asset weights.

Finally, in equity markets, you gain profits if you buy at a low price and sell at a high price, right?.

But for doing this, your emotions come in the way and also to know low and high needs a lot of expertise.

However, with this rebalancing technique without emotions and expertise involvement.

You can also achieve some good returns.

When to rebalance the portfolio?…

Generally, its a good practice to look for the opportunity at least once a year, i.e., after 1 year of investment.

However, you have to rebalance the portfolio before one year also if any asset class weight increases or decreases in a big way.

For example, 50% equity has become 60% weight after 6 months.

In addition, rebalancing gives opportunities to buy at low and sell at high, even if you do not know the exact low and high for the assets.

Portfolio Rebalancing Strategies…

  1. Calendar Rebalancing…

Most investors will do the rebalancing of the portfolio yearly once.

In addition, they will bring asset weights back to the original by adjusting the values.

But some investors will do half-yearly, quarterly, and monthly rebalancing also.

However, the more you rebalance, the more transaction costs and taxes you need to pay.

calendar rebalancing

2. Constant Mix Rebalancing…

It is a more responsive approach to rebalancing.

In addition, it focuses on allowable % composition in the portfolio for rebalancing.

And this strategy is called a constant mix rebalancing approach with bands or corridors.

Every asset class will be given a target weight and a corresponding tolerance range.

For example, an allocation strategy decided to invest in 60% equity and 40% debt with a corridor range of + or – 5%. for each asset class.

In addition, equity markets can move 20% +/- one year.

If equity gave 20% + return in year, then equity exposure in the portfolio will cross the corrior of 5%.

And the weight of equity will also increase.

Now, you have to rebalance the portfolio to bring back weight to the original.

3. Smart Beta Rebalancing…

smart beta rebalancing

Smart Beta strategy takes a rule-based approach in order to avoid the inefficiencies in index-based investing.

An index is constructed based on the market capitalisation of the stocks.

In addition, smart beta rebalancing approaches users other performance criteria like book value or return on capital to allocate the allocation across the stocks.

And this smart bet approach creates additional systematic analysis to the investment that simple index investing lacks.

In addition, this strategy is more active than index investing and less active than the stock-picking process.

Moreover, in this process, emotions are removed from the process.

Finally, depending on the way rules are set up, investors may end up trimming their top performers and increasing exposure to less stellar performers.

So, this strategy is against the old saying that letting your winners run.

But periodic rebalancing ensures you realise the reasonal profit in this strategy.

Again, this smart beta rebalancing strategy can be used to rebalance the assets based on the parameters set.

And the risk-weighted returns are often used to compare different types of investments to adjust exposure accordingly.

4. Constant Proportion Portfolio Rebalancing (CPPI)…

The most important rebalancing strategy commonly used is this constant proportion portoflio rebalancing.

In addition, in this CPPI, investors will set a floor and rupee value of their portfolio and build the asset allocation on it.

Moreover, the asset classes in CPPI are classified as risky assets, such as equity and mutual funds.

And coservative assets such as cash or it equivalant and tresurly bills.

Again, the percentage allotted to each asset depends on cushion value.

And cushion value is defined as the current portfolio value “minus” some floor value, a multiplier coefficient.

So, the greater the multiplier number, the more aggressive the rebalancing strategy.

Finally, the outcome of the CPPI strategy is somewhat similar to that of buying a synthetic call option that does not buy actual options.

Examples of Rebalancing…

Retirement accounts rebalancing…

In these accounts, investors look to rebalance frequently.

In addition, investors prefer to invest aggressively at a younger age and conservatively before the retirement age is approaching.

retirement accounts

Rebalancing for diversification…

Depending on the performance of the market.

If the stock price of X increased by 25% and the price of stock Y increased by only 5%.

Then the weight of Stock x in the portfolio will be very big and in case of sudden down turn in stock X, the portfolio will

suffer huge losses.

So, some portion of X will be sold, some portion of Y will be bought or a new stock will be bought.

or a new stock or asset will be bought.

Advantages and disadvantages of rebalancing…
Advantages of rebalancing…
  • Rebalancing helps you to align with your risk tolerance. In addition, it ensures a certain amount of return.
  • And it maintains a predetermined asset allocation set by the investment plan.
  • Moreover, its disciplined, unemotional approach reduces risk.
  • And On change of investor financial need and goal, the rebalancing technique may be changed.
  • Financially, rebalancing can be done by experienced investors or with the help of investment managers.
Disadvantages of rebalancing…
  • Rebalancing involves transaction costs, which may reduce the total return.
  • In addition, selling stocks at higher levels means you may lose the further upside potential of that particular stock.
  • Moreover, rebalancing requires experience and knowledge to implement.
  • And unnecessary rebalancing can increase the tax burden and costs to the investor.

Does rebalancing have costs?…

Yes, in rebalancing while buying and selling stocks or assets.

Then, you need to pay transaction costs and taxes.

In addition, if you are selling stock that is in an uptrend,.

And the furthur upswing, if any left, you will lose it.

How frequently should you rebalance? …

Generally, long-term investors rebalance their portfolio once in a year.

But the short-term investors can do rebalancing once in a month also.

Read an article about strategic asset allocation—all you need to know…

Also read about the tactical asset allocation.

And read about asset allocation and its importance.

Also read about dynamic asset allocation—all you need to know.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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