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What You Need to Know about Rebalancing a Portfolio

The term rebalancing gets used a lot in the investment management world. When advisors use it, e.g., “We will rebalance your portfolio,” it can mean a number of things. This blog will help you understand what exactly rebalancing is, and why it helps keep a portfolio in line with your financial goals.

Rebalancing in the most basic sense is the process of returning an investment portfolio to its agreed upon allocation targets. Typically, advisors will assign a fixed percentage of an overall portfolio to various asset classes that are intended to represent the desired long-term objectives of the portfolio. When assigning asset class targets, advisors will consider the expected risk/return metrics of each asset class and determine their target weights going forward.

Advisors will deploy funds to each asset class based on the initial target weights assigned. After the initial allocation, the market for each asset class will begin to fluctuate. Some asset classes move around more than others and one of the goals of a diversified allocation is to blend asset classes together that move differently than each other (low/negative correlation), resulting in a less volatile portfolio experience.

How does rebalancing work?

Now that the initial targets are set, funds deployed, and markets moving, what happens next? Rebalancing! Even one day after the initial investments are made, the portfolio targets will likely be off their initial levels.

As an example, let’s say we had a simple portfolio: 50% S&P 500 (SPY) and 50% Barclays Aggregate Bond Index (AGG). In the first week after the initial deployment, SPY has a stellar week and is now 70% of the portfolio. AGG has a quiet week and stays stable but is now only 30% of the total. At this point, we have a 70% SPY–30% AGG allocation, which could be far more volatile than our original 50%–50% split. The difference in the risk/return characteristics of the portfolio have changed and now our allocation is more aggressive.

Since the client and advisor initially agreed on the 50%–50% split, it is likely time to rebalance. In this example, we would recommend selling the amount over our target allocation from SPY (taking advantage of higher prices) and buying more of AGG. While this may be counterintuitive at times, selling the asset that has done well to buy an asset that has performed less well is a systematic way to sell high and buy low.

Think about the same situation with opposite market movements. Let’s say SPY had a bad week and is now 30% of the total. In this scenario, we would sell AGG, which is still stable but now 70% of the total and buy SPY up to our 50% target (taking advantage of lower prices).

In both cases, we have returned the portfolio to its allocation targets and have taken advantage of higher prices on the sell side and lower prices on the buy side. We have also maintained the desired risk/return metrics of the portfolio.

Why rebalance?

In a perfect, cost-free world, in theory we would place trades to return the allocation to its targeted amounts on a frequently recurring basis. In the real world, there is a cost to rebalancing. Trade commissions, taxes, and bid-ask spreads are all examples of that. Thus, the optimal frequency of portfolio rebalancing depends on a few details. What is the overall cost of the rebalance? And do the benefits outweigh those costs? Here are some of the core benefits:

Maintaining a portfolio allocation with consistent risk/return expectations.

By staying disciplined to the target allocation, we may be provided with insight into how the portfolio will react to changing market conditions throughout time, giving us a better idea of how to plan for future objectives.

Staying unreactive to fast changing markets.

By sticking to the target allocations, we move away from emotional (and sometimes irrational) decision-making. With disciplined periodic rebalancing, we lessen the chance of bailing out of falling markets or stretching for additional returns.

Having a strategy for up and down markets.

Markets can have wild swings and can cause investors to make bad decisions. We believe that disciplined rebalancing allows clients and advisors to plan for up and down markets and discuss the strategy in advance (buy low/sell high), helping keep clients from losing too much sleep.

When or how often should rebalancing be considered?

Now that you have an idea why it is beneficial to rebalance and maintain asset class targets, let’s look at frequency. There are really four main reasons to consider rebalancing:

  1. Cash deposit
  2. Cash withdrawal
  3. Changing portfolio objectives or life change
  4. Variance to targets

The first two items are fairly self-explanatory, so we will cover the last two.

When managing a portfolio for a long period of time, it is highly likely that initially identified portfolio objectives will change. Marriage, birth of a child, change in health, and retirement are all examples of how life can change. When this happens, clients and advisors should revisit investment objectives and update the allocation targets to reflect the new portfolio goals. At the end of the day, life happens, and sometimes your financial plan needs to adjust to account for it.

The last item is the most common rebalance trigger. Markets move on a constant basis, meaning every day the value of the current holdings changes. As they change, the variance between the current weight of each asset class and its target weight gets bigger and smaller. Just like the SPY/AGG example above, as SPY goes from its 50% target to 70%, that would mean its variance went from 0% to 20%. These variances become important, as advisors need to gauge how much variance they’re willing to tolerate against the costs to correct them. If the variance bands are too tight, say <1%, rebalancing may need to occur every day, which could increase the cost. If they are too big, then the portfolio may drift either too aggressive or too conversative, changing the risk/return metrics.

At Columbia Pacific Wealth Management, we target variances greater than 1.5%–2% as a guide for when it is time to rebalance an asset class. As advisors, one of our portfolio management responsibilities is to make sure we monitor the investment markets we recommend for our client portfolios. As the various markets move, advisors need to pay attention to the resulting impact on portfolio allocations. For example, in 2021 the S&P 500 (SPY) is up 11.50%, meaning all portfolios that own U.S. stocks will likely be overweight to that asset class. In addition to being aware of how various capital markets are moving, we also aim to review individual portfolio targets semiannually, usually coinciding with client investment review meetings.

After reviewing the benefits and the costs of rebalancing, its technical definition, and why it is an important part for long-term portfolio management, it should be clear that rebalancing can be a tool to help investors stay disciplined and remove emotions from their long-term financial plan. Additionally, it creates a plan for different market conditions and life events and helps maintain an asset allocation based on the overall portfolio objectives. We hope this blog helps you understand what rebalancing is, why it’s important, and how it helps your portfolio on its path to achieving your financial goals. Have questions about rebalancing or any other investment management strategy? Contact us to learn more.

Important Disclosure Information:

Different types of investments involve varying degrees of risk, including the risk of loss of your entire investment. Past performance is not indicative of future results. CPWM and its employees can give no assurance that the performance of any specific investment recommendation or investment strategy discussed herein, whether directly or indirectly, will be profitable, or that it will be equal to any historical performance level discussed herein. The discussion or information contained herein is not intended to be, and should not be deemed as, personalized investment advice. The recommendations made may not be suitable for your specific individual situation and we encourage you to discuss with your financial professional before undertaking any investment strategy or recommendation contained herein. The discussions contained in this blog is current only as of the date hereof and may change due to a number of factors, including varying market conditions.

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