Portfolio rebalancing is a powerful risk management investment strategy which involves buying or selling investments to achieve a desired asset allocation.
Rebalance Because of a Change in Asset Prices
Over time, as a portfolio’s assets change in price it can easily move the portfolio to a position that risk and return become inconsistent with an investor’s goals and risk preferences. As some assets increase they make up a larger percentage of the portfolio; at the same time, the declining assets become a smaller percentage. If an investor does not rebalance the portfolio it will gradually move to high return and higher risk investments.
Portfolio rebalancing forces an investor to buy low and sell high. For example, let’s say you have a target asset allocation of 40% for asset category A and a target asset allocation of 40% for asset category B. Then let’s assume asset A increases 50% and asset B declines by 50%. Now you own 3 times as much asset A compared to asset B because asset A has increased to 60% of the portfolio and asset B has declined to 20% of the portfolio. After these fluctuations, not only is your asset allocation out of balance, but now you own more of an asset category that has just risen 50% and may be overvalued and own less of an asset that may be undervalued. Rebalancing allows an investor to sell overvalued asset and buy undervalued assets.
Rebalance to Change Your Target Asset Allocation
An active or tactical asset allocation strategy uses rebalancing to take advantage of volatility by being more conservative when an asset price is high and more aggressive when an asset price is low. Take the above example; with asset category A up 50% and asset category B down 50% an investor may choose to move his target asset allocation to reflect the relative risk of each asset. Instead of rebalancing to 40% each, an investor may decide that asset category A, because it is now overvalued should only be 30% of the portfolio, and asset B, because it is undervalued, should be 60% of the portfolio. If done correctly, the portfolio is still diversified but now has less risk and greater potential for appreciation at the same time.
Flexibility makes a tactical asset allocation strategy superior to a static buy and hold strategy. Buy and hold strategies do well as long as the market is rising, but do poorly during flat or bear markets such as we have experienced in the past decade.
Differences Between Static and Active Asset Allocation
There are two main differences between a static asset allocation and an active or tactical asset allocation strategy. An active asset allocation requires frequent or regular rebalancing; and second, an asset allocation decision must be made for each asset category based on the current opportunities and risk. This doesn’t mean the asset allocation has to change, but an investor has the flexibility to change with changing conditions. A tactical asset allocation requires paying attention to your investment portfolio. However, the reward can be much higher portfolio returns and/or less risk.
Portfolio rebalancing due to a change in asset prices or to alter your asset allocation are both powerful risk management strategies. Use rebalancing to manage risk and improve your returns.