While diversification has long been accepted as a valuable component of a risk-managed portfolio, another powerful mechanism which can be used to minimize risk is portfolio rebalancing. Rebalancing is the systematic reallocation of assets within a portfolio either on a periodic or conditional basis.
To illustrate rebalancing, let’s look at an example. Suppose we invested $100 in a portfolio consisting of 50% stocks and 50% bonds. In this scenario, $50 would be invested in each asset class.
Over time, increases in the market prices of the underlying instruments may cause this investment to grow to $300. Since stocks tend to fluctuate more rapidly (or be more volatile) than bonds, the ratio of stocks to bonds within the portfolio may change over time.
As a result, the $300 ending value might consist of $210 in stocks and $90 in bonds. Since each allocation originally began at a value of $50, we can see that stocks increased in value to a greater extent than bonds, and as such, currently represent a greater portion of the overall portfolio.
Although the overall value of the investment has increased, the greater allocation to stocks means that any decrease in their value can potentially have a more significant downside influence on the overall portfolio. This may bring the overall risk level of the portfolio beyond that of the investor’s risk tolerance or capacity.
In this situation, rebalancing can be used to bring the portfolio back to the original intended risk/return ratio while maintaining its current appreciated value. In the above example, stocks (which currently comprise 70% of the portfolio) would be sold to bring the allocation of stocks back down to 50%, and bonds (which currently represent 30% of the portfolio) would then be purchased to bring the allocation back up to 50%.
The result of the rebalancing is a portfolio recalibrated to provide the returns sought by the investor while bringing the risk down to an acceptable level. Although rebalancing can be useful in bringing a portfolio back to its original risk/return characteristics, it can also be employed in response to changes in security prices, client circumstances, the financial markets, politics, or evidence that such changes may be likely to occur.
While portfolio rebalancing can make portfolios more flexible to changing conditions, it also allows investors to systematically “buy low and sell high” if a particular certain asset class experiences significant price appreciation within a short period of time. This might be a significantly advantageous to the investor because periods of outperformance may be followed by profit-taking by other market participants which puts pressure on asset prices. Additionally, short sellers, if significant enough in volume, may cause the price of a security to decrease after periods of outperformance. Therefore, it is important to employ a systematic and non-emotional approach of buying and selling which reduces exposure to downside market movements. This is an area in which portfolio rebalancing may be particularly useful.
When performing portfolio rebalancing, a comprehensive research-driven methodology is necessary. The goal is to avoid a mere exchange of outperforming asset classes for those which are underperforming, something which can negatively impact future returns. Alternatively, a more appropriate strategy might involve the construction of a new portfolio which includes securities and asset classes not previously held. This generally requires careful analysis of the financial markets, the political climate, and various qualitative and quantitative factors to maximize the changes for success while adhering to the predetermined risk/reward characteristics sought by the investor. Since every security type carries associated risks, certain types may be incompatible with an investor’s financial situation, goals, or risk tolerance.
Today’s portfolios are often just as dynamic and unique as the investors who hold them, and as such, this serves as only a partial listing of factors which must be taken into consideration when rebalancing a portfolio. Although there are unfortunately no guarantees against loss, diversification and rebalancing may serve as powerful tools to manage risk and minimize volatility within a portfolio.