3 Smart Portfolio Rebalancing Strategies for Retail Investors

By Chika


Last Updated: December 28, 2021


Rebalancing a portfolio is the act of adjusting weightings through the buying or selling of assets to restore target allocations or risk levels over time.

It is an essential component of the portfolio management process.  

Portfolio rebalancing is simply the maintenance of your investments. It revolves around managing risk at tolerable levels rather than maximizing returns.

In essence, though the practice advocates the "sell high, buy low" investment rule, it is also predicated on trimming positions in more risky assets to more 'stable' assets. 

Professional money managers use systematic ways to rebalance portfolios for clients. These moves are usually propelled by heavy quantitative analysis and due diligence. However, retail investors can also replicate these strategies and adjust their investment holdings accordingly. 


3 Reasons You Should Rebalance Your Portfolio

There are several reasons why it is appropriate to rebalance your portfolio. Let's have a look at some of them: 

1. Rebalancing for risk

Primarily, portfolio rebalancing safeguards the investor from being overly exposed to undesirable risks.

When your portfolio is over-exposed to an asset or sector, it is advisable that you rebalance your portfolio. Being overly exposed to a sector or assets increases your risk.

This implies that the volatility on that single asset or sector would have a considerable effect on the whole of your portfolio.  As such, it is appropriate to rebalance to maintain a considerable level of risk to reduce the effects of volatility and potential drawdowns on your portfolio. 

2. Target asset allocation

Rebalancing your portfolio is the only way to stay on track with your target asset allocation—the percentage of your portfolio that’s held in different investments, such as 80% stocks and 20% bonds.

Your target asset allocation is the percentage you want to hold in each investment so that you’re comfortable with how much risk you’re taking and are on track to earn the investment returns you need to meet your goals, such as being able to retire by age 65.

3. Rebalancing for return

Investors rebalance portfolios to optimize returns on their assets.

The financial markets are susceptible to business cycles as determined by the macroeconomy. As such, the performance of assets fluctuates as the business cycles change. To get the best returns at any given cycle, investors need to rebalance their portfolios. 

Sometimes some assets may outperform, making their size bloated to other assets in the portfolio. An experienced investor would take profits from such assets and invest them in other underperforming assets. Doing so helps to maintain the balance and structure of the portfolio. 

For example, during periods of rising interest rates, high-growth stocks usually underperform because their valuations are based on future earnings.

On the flip side, assets such as real estate, financial stocks, and utilities perform well during this period. As such, an investor who is heavily exposed to high-growth stocks would have his portfolio underperform during such a period. 


3 Strategies of Portfolio Rebalancing

There are several portfolio rebalancing strategies that investors can utilize to create an optimal investment process.

1. Percentage-of-Portfolio Rebalancing

This is a portfolio rebalancing strategy based on the percentage of each asset in relation to the whole portfolio.

Here, every asset class, or individual security, is given a target weight and a corresponding tolerance range. When the assets exceed that percentage, the investor trims his position to maintain balance in the overall portfolio. 

For example, an investor may have a 2% asset allocation. This means that no asset in his portfolio would be more than 2% of the overall portfolio. If the price of an individual security increases due to outperformance from bullish moves, the investor trims his position in that security, bringing it down to 2%.

2. Calendar Rebalancing

Calendar rebalancing is the most rudimentary rebalancing approach.

This strategy entails rebalancing your portfolio periodically (monthly, quarterly, bi-annually, or annually). Monthly and quarterly rebalancing is the most preferred of this type of rebalancing strategy. The analysts uses time as his parameter for rebalancing, before considering other factors such as risk or macroeconomy. 


CPPI (Constant Proportion Portfolio Insurance) is a sort of portfolio insurance in which the investor establishes a threshold for the portfolio and thereafter constructs asset allocation around that choice. 

For example, an investor may decide to invest $10,000, of which he decides $9,000 is the absolute floor. If the portfolio falls to $9,000 in value, the investor would move all assets to cash to preserve capital.

A risky asset (typically stocks or mutual funds) and a conservative asset (generally cash, equivalents, or treasury bonds) are the two asset types employed in CPPI. The proportion allotted to each asset is determined by a multiplier coefficient and a "cushion" value, which is defined as the current portfolio value minus floor value. 

If 20% is the maximum cap "crash" possibility, the multiplier value will be (20/100 x 100), or 5.

Based on the information provided, the investor would allocate 5 x ($100,000 - $90,000) or $50,000 to the risky asset, with the remainder going into cash or the conservative asset.


When Should You Rebalance Your Portfolio?

There is no appropriate time to rebalance a portfolio.

Research from Vanguard shows there is no optimal rebalancing strategy. Whether a portfolio is rebalanced monthly, quarterly, or annually, portfolio returns are not markedly different. The needs of every investor or trader are unique.

The reasons for investing in an asset are predicated on risk asset, capital, knowledge, time, and experience.

As such, these factors coalesce into an investment style, which ultimately determines how an investor may wish to rebalance his portfolio. While some investors use time as a factor, others use percentage allocation or macroeconomic factors. 

Be warned that frequent tracking of your investments can lead to making emotional decisions in the heat of the moment instead of sticking to your long-term goals.

Several studies of behavioral finance reveal investors might be tempted to alter asset allocations based on market volatility instead of their financial goals. Despite how often you check, the objective is to maintain a balanced risk profile over time. The key thing is understanding your unique situation and rebalancing accordingly.


The Bottom Line

Portfolio rebalancing offers much-needed protection for your assets.

It also ensures that investors stick to a disciplined routine and adjust their portfolios accordingly to mitigate risks. There is no cut-and-dry method when it comes to portfolio rebalancing, as each investor's needs are different and unique.

The ideal balancing strategy will balance out the overall needs of rebalancing with the explicit costs associated with the strategy chosen.

Photo by Adeolu Eletu on Unsplash


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