Rebalancing: Methodical Asset Realignment
Abstract
This guide emphasizes the crucial role of asset realignment in effective portfolio management. It advocates for disciplined, regular reassessment to align portfolios with risk profiles and addresses emotional challenges associated with the process. The guide explores optimal rebalancing frequencies, introduces advanced strategies like Trigger-Based and Forward-Looking Rebalancing, and touches on practical considerations such as allowing portfolios to drift. Concluding with insights into dynamic asset allocation strategies, it serves as a concise resource for investors seeking a systematic approach to maintaining optimal portfolios.
Time to read: 4 to 5 minutes.
Level: Fundamental.
Category: Education Note.
Methodical Asset Realignment for Investors
Non-rebalancing of an investment portfolio over time can result in a significant deviation of its asset class allocation from the investor's predetermined risk profile. It is recommended that investors meticulously reassess their current asset class exposure and realign the main building blocks of their portfolio in accordance with their risk profile. Rebalancing should be considered a crucial aspect of portfolio management, achieved through regular reviews or the establishment of maximum deviation thresholds.
The process of rebalancing entails reducing exposure to outperforming assets and increasing allocations to underperforming ones, a risk-conscious strategy despite its counterintuitive nature. Failure to rebalance may expose investors to excessive risk or hinder their ability to capitalize on market upswings.
Rebalancing, essentially "selling high and buying low," primarily serves as a risk management tool. Despite incurring costs, it compensates by smoothing return volatility, alleviating the stress associated with achieving the optimal asset allocation for diverse market conditions. Investors must acknowledge the emotional challenges of rebalancing and adopt a disciplined approach, overcoming natural anxiety to move against prevailing trends.
Asset allocation is a conscious and recurring decision. Investors not engaging in portfolio rebalancing may achieve an optimal allocation through luck, contingent on factors such as the investment holding period. However, it is equally likely that many investors deviate from their risk-return profile over time. Rebalancing is not universally desirable, as an investor's risk-return characteristics may change. If an investor is fully aware of and agrees to the risk-return characteristics of their current portfolio, rebalancing may not be necessary. However, regular portfolio reviews are crucial to ensure alignment with the investor's risk profile.
Determining the optimal rebalancing frequency lacks a one-size-fits-all approach due to the unpredictable movement of assets. Both academic literature and practical examples suggest that more frequent rebalancing may negatively impact performance due to increased trading activity. Comparing monthly, quarterly, and annual rebalancing over the past two decades, an optimal period for our two-asset case is found to be yearly, considering trading costs.
Trigger-Based and Forward-Looking Rebalancing Strategies for Risk-Aware Investors
An alternative to calendar-based rebalancing is a trigger-based approach, setting a deviation threshold (e.g., 10%) to initiate the rebalancing process. This method better controls asset drift and is suitable for risk-conscious investors. Professional investors often use varying limits for different asset classes due to differing volatilities. Increased volatility in fixed income may necessitate adjusting trigger levels for those using a trigger-based approach.
For investors with a short investment horizon, allowing the portfolio to drift may be practical. To avoid transaction costs while regularly rebalancing, utilizing cash flows from dividends, coupon payments, and new capital is a convenient approach.
Use a forward-looking rebalancing approach Rebalancing works well when asset prices show reversals. The investor would then buy an asset during a downturn and sell during an upturn, just before prices would reverse again. However, during longer-lasting as- set price movements in one direction, regular rebalancing can lead to an investor selling well-performing assets and buying poorly performing ones too early. We therefore propose that investors use a forward-looking approach when making rebalancing decisions. This means they should not just adjust their portfolio weights completely back to their initial levels, but rather deviate at pre-defined targets, depending on the short- to medium-term outlook of the respective asset classes.
Dynamic Strategies for Asset Allocation
The best reference in this area belongs to the paper “dynamic strategies for asset allocation, by william Sharpe” was published in 1988 and co-authored by Andre F. Perold. It explores four different portfolio management techniques that adjust the weights of different asset classes according to market conditions and performance. The paper compares the risk and return characteristics of these strategies and discusses their implications for investors.
The four strategies are:
Buy-and-hold: This strategy involves holding a fixed proportion of wealth in risky assets (such as stocks) and safe assets (such as bills) and not rebalancing the portfolio in response to market changes. This strategy has a linear relationship with the stock market performance and does not require active management.
Constant mix: This strategy involves holding a constant fraction of wealth in risky assets and rebalancing the portfolio periodically to maintain this fraction. This strategy effectively sells stocks when the market rises and buys stocks when the market falls, thus providing some diversification and risk reduction.
Constant-proportion portfolio insurance (CPPI): This strategy involves setting a floor value for the portfolio and allocating a variable proportion of wealth to risky assets based on the cushion between the current portfolio value and the floor value. This strategy provides downside protection and upside potential by increasing the exposure to stocks when the market rises and decreasing it when the market falls.
Option-based portfolio insurance (OBPI): This strategy involves buying a put option on the stock market index and investing the remaining wealth in a risk-free asset. This strategy replicates the payoff of a CPPI strategy but does not require dynamic rebalancing.
The paper analyzes the performance of these strategies under different scenarios of stock market behavior, such as trend, volatility, and mean reversion. The paper finds that:
Buy-and-hold and constant mix strategies are more suitable for long-term investors who have a stable risk tolerance and do not need downside protection.
CPPI and OBPI strategies are more suitable for short-term investors who have a variable risk tolerance and need downside protection.
The popularity of one type of strategy may affect its cost and benefit, as well as the performance of the opposite strategy. For example, if many investors buy portfolio insurance, the demand for stocks may increase when the market rises and decrease when the market falls, thus amplifying the market movements and making the insurance more expensive.
The choice of strategy depends on the investor’s preferences, beliefs, and constraints. There is no single optimal strategy for all investors.
The paper concludes that dynamic strategies for asset allocation are useful tools for portfolio management that can help investors achieve their objectives and cope with market uncertainty. However, the paper also warns that dynamic strategies are not without challenges and limitations, such as implementation costs, estimation errors, and market inefficiencies. Therefore, investors should carefully evaluate the benefits and risks of dynamic allocation before adopting it.
References:
Bogle, John C. The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns. 2nd ed. Hoboken, NJ: John Wiley & Sons, 2017.
Bernstein, William J. The Four Pillars of Investing: Lessons for Building a Winning Portfolio. New York: McGraw-Hill, 2002.
Swensen, David F. Unconventional Success: A Fundamental Approach to Personal Investment. New York: Free Press, 2005.
Malkiel, Burton G. A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing. 12th ed. New York: W. W. Norton & Company, 2019.
Ferri, Richard A. All About Asset Allocation. 2nd ed. New York: McGraw-Hill, 2010.
