Investing, Stocks

Optimize Your Long-Term Strategy With Portfolio Rebalancing

Written By: Lyster Rosales
Reviewed by: Mike Reyes
Last Updated June 15, 2023
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A Balance Scale on a Woman's Table

Maintaining a portfolio is a difficult process. Preserving its returns and growing it further is an even more difficult task. It takes a lot of skill, patience, and understanding of the market to be able to “hold on to your winners and let go of your losers.” But what if you can systematically remove securities that are no longer providing you the performance to meet your financial goals in your strategy? Sounds interesting right? Then let me introduce the concept of portfolio rebalancing.

What is portfolio rebalancing?

Portfolio rebalancing is an investment strategy used to maintain a desired amount of allocation or exposure of an investment portfolio to certain assets, sectors, factors, or securities. This involves periodically realigning a portfolio’s composition to various types of holdings for investments to ensure that the portfolio remains consistent with the prescribed level of risk tolerance and long-term financial goals for holdings like retirement investments

Original Holdings

After Rebalancing

Understanding Portfolio Rebalancing

It is important to be familiar with the general ideas about the concept to better understand how to rebalance your portfolio.

Asset Allocation

Asset allocation is a method used to divide investments among different asset classes, factors, etc., and see a portfolio’s exposure to a certain asset, sector, or other factors and determine which areas they can optimize risk and return. It is one of the foundations of an investment portfolio that plays a crucial role in helping achieve an investor’s long-term financial goal. With the diversification into different asset classes, sectors, or different factors, investors may reduce the impact of large market movements and potentially enhance returns.

Portfolio Drift

Due to the varying performance of different asset classes, sectors, etc., the initial asset allocation of a portfolio can change from its original intended weighting. This drift can lead to exposure to unintended risks or over-concentrated positions. The portfolio is employed to restore its intended allocation composition and align it to the desired risk profile.

Strategies for Portfolio Rebalancing

People Discuss About Graphs and Rates

Investors can apply portfolio rebalancing strategies in different ways. These can be done on a specific frequency, like holdings percentage or a combination of different strategies. Here are some options that investors can employ:

Calendar-based 

This method involves rebalancing the portfolio at specific intervals, such as quarterly, semi-annually, or annually. Calendar-based rebalancing requires a disciplined approach and ensures that regular adjustments to the portfolio’s allocation are needed to meet the portfolio investment goal regardless of market conditions. 

Percentage-based 

This portfolio rebalancing method focuses on maintaining allocations of a particular factor to a certain percentage. For example, if the portfolio allocation to stock investments is 60%, and the current holdings of stocks exceed 65% or go lower than 55%, the strategy would require the investor to rebalance. This method allows investors to focus on capturing the benefits of long-term market trends. However, this can also be costly in volatile markets due to the potential frequency of rebalancing.

Hybrid 

This rebalancing method combines different strategies or uses a dynamic approach based on market conditions. For example, you can combine a calendar-based and a percentage-based approach to maintain the portfolio’s desired allocation and consider market trends. This strategy offers flexibility and customization. However, this may also require an active management approach.

Benefits of portfolio rebalancing

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Now that we understand what portfolio rebalancing is and what strategies can be employed, let’s look at its benefits to an investor’s investment goals.

Risk management

Rebalancing helps manage risk by ensuring the portfolio’s asset allocation remains aligned with the investor’s risk tolerance. It helps reduces the likelihood of having too much exposure to a single asset, sector, or factor that may become riskier over time.

Discipline and long-term perspective

Adopting regular rebalancing in the investment process enforces discipline and discourages making emotional decisions based on short-term market fluctuations. It helps promotes a long-term investment approach and prevent investors from chasing hot sectors or recency biases.

Focus on buying low and selling high 

Since rebalancing involves selling a portion of the outperforming holdings to buy more of the other holdings with a lower allocation, this lets investors also take advantage of low prices and systematically capture gains from winners and potentially benefit from the recovery of an underperforming asset. This, in turn, can potentially enhance their long-term returns.

Cons of portfolio rebalancing

Like any strategy, portfolio rebalancing has its flaws. Understanding them allows investors to make informed decisions or add certain limitations to their strategy to ensure that everything still falls within their risk appetite and long-term goals.

Transaction Costs

As rebalancing incurs costs, such as brokerage fees, taxable transactions, and bid-ask spreads (depending on your brokerage account), frequent instances can result in higher expenses that may impact performance, especially in smaller portfolios. Investors must weigh the potential benefits of rebalancing against the costs of employing this in their strategy.

Missed Opportunities

Rebalancing can cause investors to miss out on potential gains depending on the market conditions. For example, when a particular set of holdings is experiencing a significant uptrend and the rebalancing may involve selling some of the shares, this can potentially limit the investor’s exposure to further gains. It is important to find the right balance between the benefits of rebalancing and the potential opportunity costs that comes with it.

Timing Risk

Timing the market is one of the toughest things an investor has to do. Attempting to time it while rebalancing can be more challenging. With unpredictable markets, rebalancing too frequently based on short-term market volatility can result in unnecessary trading. As a result, the portfolio may not generate consistent performance, and the investor can miss out on opportunities due to early rebalancing.

Best practices for portfolio rebalancing

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Implementing a clear objective and investment goal is the start of having a good investment process. Setting out your objectives can help lay the groundwork for your rebalancing strategy. Having a clear set of rules like target allocation, rebalancing frequency, and investment horizon can be a start. This helps investors easily monitor their portfolio performance and if their holdings are still within their risk tolerance, deviate from their goals, or it is in line with their investment objective.

Final thoughts

Employing processes like rebalancing is one of the ways an investor can fine-tune their investment strategy. Regardless of their focus being on specific assets like stocks or bonds or even multi-asset strategies, adopting a systematic approach to optimize a portfolio can provide long-term benefits by instilling discipline and regularly reminding investors of their long-term goal for investing. Like with any strategy, it is important to always understand its limitations to have realistic expectations on any investment decision.

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