Rebalancing

Definition

Rebalancing is the process of periodically adjusting the composition of an investment portfolio to maintain its desired asset allocation. It involves selling over-performing assets and buying under-performing ones to maintain the initially established risk and return profile. This process helps investors stay on track with their investment goals while mitigating risk caused by market fluctuations.

Phonetic

The phonetics of the keyword “Rebalancing” is: /ˌriːˈbalənsɪŋ/

Key Takeaways

1. Rebalancing is a process that involves periodically adjusting the asset allocation in an investment portfolio to maintain the desired level of risk and return. This is essential for ensuring that the portfolio’s performance continues to align with the investor’s financial objectives and risk tolerance.
2. There are various methods for rebalancing, such as time-based, threshold-based, or a combination of both. Time-based rebalancing involves regular reallocation of assets at predetermined intervals (e.g., quarterly or annually), while threshold-based rebalancing occurs when an asset’s allocation deviates from the target allocation by a specific percentage.
3. Regular rebalancing helps to manage risk in the portfolio by preventing the overexposure to certain assets or asset classes. It also allows investors to take advantage of market fluctuations by buying undervalued assets and selling overvalued ones, promoting a disciplined and systematic approach to investing.

Importance

Rebalancing is an essential practice in the realm of business and finance as it maintains an investor’s desired risk-reward profile within their investment portfolio. Over time, the value of different assets changes, leading to deviations from the original asset allocation. Rebalancing involves periodically adjusting these allocations by selling or buying assets to restore the intended proportions. This crucial mechanism not only keeps the investments aligned with an investor’s long-term goals and risk tolerance but also promotes disciplined investing by encouraging investors to buy low and sell high. Furthermore, rebalancing allows investors to capture gains from well-performing assets to reinvest in underperforming ones, resulting in reduced portfolio volatility and improved long-term performance.

Explanation

Rebalancing, as a core aspect of portfolio management, serves the essential purpose of maintaining the desired risk-return profile, which is vital for investors to achieve their financial goals. Over time, market fluctuations cause asset allocation within a portfolio to deviate from its target, which can expose investors to unintended levels of risk or potential missed opportunities. By periodically adjusting asset allocation back to the desired targets, rebalancing ensures that a portfolio remains aligned with investor’s objectives, risk tolerance, and investment time horizon. This process involves trimming over-performing assets and reinvesting in those that have underperformed relative to their target allocations. Importantly, this tactic helps mitigate the emotional biases of investors and fosters a disciplined approach towards investing, making it a critical aspect in preventing unnecessary risks. In practice, rebalancing helps investors achieve diversification—a key principle in investment management that advocates reducing the overall risk of a portfolio by investing in various assets with little to no correlation. Rebalancing can be implemented through different methods, such as calendar-based, threshold-based, or using a combination of both strategies. By systematically repositioning the weights of portfolio components, rebalancing can harness the potential of various investments and ensure that no single asset dominates the portfolio’s performance. Furthermore, the regular practice of rebalancing can boost long-term returns by capitalizing on the “buy low, sell high” investment strategy. In essence, rebalancing serves as an indispensable tool for investors, aiming to maintain a well-diversified and risk-adjusted portfolio, thereby enhancing the likelihood of achieving their desired financial outcomes.

Examples

1. Retirement Portfolio Rebalancing: John, a 45-year-old professional, has a retirement portfolio consisting of 60% stocks and 40% bonds. He initially set this allocation to achieve a balance of growth and risk. Over the year, the stock market has performed well, and his stocks’ value has increased, causing an imbalance in his desired allocation. To rebalance his portfolio, John sells some stocks and purchases more bonds to return to his target allocation of 60% stocks and 40% bonds. 2. Rebalancing Mutual Funds: Many mutual funds are designed with specific target allocations, such as a 70% equities and 30% fixed income mix. After a period of strong stock market performance, the equities portion of the fund may exceed its target allocation, leading fund managers to rebalance the mutual fund. The fund managers sell some equities and purchase fixed-income assets to bring the fund back in line with its intended allocation. 3. Exchange-Traded Fund (ETF) Rebalancing: ETFs are designed to track specific indexes or follow a certain investment strategy, which involves maintaining set allocations to different asset classes or sectors. For example, an ETF that tracks the S&P 500 index must rebalance periodically to accurately reflect the changing weights and components of the index. ETF managers achieve this by selling or purchasing assets to match the exact allocations required to mirror the performance of the index they track.

Frequently Asked Questions(FAQ)

Related Finance Terms

• Asset Allocation
• Portfolio Diversification
• Investment Risk Management
• Target Weight
• Performance Monitoring

Sources for More Information

• Investopedia
• Experian
• Bankrate
• Wikipedia