rebalancing your portfolio


In a recent meeting a client asked, “How do you rebalance my portfolio?”


When discussing investment portfolios, most of the focus tends to be on asset allocation, security selection and market performance; however, rebalancing your portfolio is quite important, because it maintains fundamental integrity. Having a portfolio rebalancing strategy provides protection, so it will not deviate more than a predetermined amount from the targeted asset allocation. This is important because the asset allocation of your portfolio provides an understanding of the amount of risk within the portfolio, as well as an expected rate of return.


Before I go further into how we rebalance portfolios, it’s important to notate the definition of “rebalancing” if you are not yet familiar with the process. According to Investopedia, rebalancing a portfolio is the process of realigning the weightings of one’s portfolio of assets. Rebalancing involves periodically buying or selling assets in your portfolio to maintain a desired level of asset allocation.


Your asset allocation model is designed to match your cash flow needs, time horizon and aversion to risk. We design the asset allocation model to provide the highest potential return with the least amount of risk necessary in order to meet your goals. Given the importance of determining the right asset allocation model, a strategy is necessary to make sure that this model stays within an acceptable range of that original targeted asset allocation. That is where portfolio rebalancing comes into play.


Due to market forces, portfolios will deviate over time from the expected risk-return profile of the asset allocation model. Generally, portfolios become riskier if they are never rebalanced, simply because higher-return assets tend to have significantly higher risks. By not rebalancing your portfolio, an initially diversified portfolio will become less diversified over time.


We utilize a rebalancing process based on deviation from targets. This is also referred to as a threshold rebalancing strategy, or a tolerance band rebalancing strategy. After the asset allocation model is constructed, we then set an allowable tolerance to deviate from the targeted allocations to each asset class. For instance, an allocation model may have a 15% allocation to an asset class, such as large-cap U.S. stocks, with a 5% tolerance.  That means the asset class will not be reallocated back to 15% unless it is at more than 20%, or less than 10%.


In addition to rebalancing portfolios via deviation from targets, we also utilize the inflows and outflows of portfolios to rebalance. For example, if a portfolio is out of alignment from the targeted allocation, but within the acceptable tolerance bands, it would not be rebalanced; however, in this scenario when a portfolio deposit or withdrawal occurs, we use this change to bring the portfolio into better alignment with the target allocation.


A disciplined process of rebalancing a portfolio is essential. It helps ensure a portfolio remains invested with the same amount of risk as originally intended. It also allows us to rely on a strategic process for making investment decisions instead of emotionally reacting to what is currently happening in the market.