Since the weightings of the constituents of a portfolio are constantly changing due to the fluctuation of prices in the securities markets, investors have to ensure that the weightings of the single asset types and classes (the asset mix) stays in line with their risk bearing capacity (risk tolerance) and the respective guidelines of their portfolio. The process of realigning the portfolio with the guidelines or benchmark of a portfolio is called rebalancing.
That said, rebalancing is a simple and well-known technique to help the investor to stick to his investment plan by regularly aligning the constituents of a portfolio with their target weightings (strategic asset allocation). In addition, rebalancing can also help to increase the (risk-adjusted) return of the portfolio, since the investor sells securities which have done well within the rebalancing period and buy those securities which haven’t.
The rebalancing frequency is depending on the asset mix within the portfolio and can be anything between one day and annually. In some cases, even shorter. That said, not all rebalancing frequencies make sense from an investor’s point of view. Since any rebalancing involves transaction costs and has tax implications, investors need to find the sweet spot where the transaction costs for the rebalancing don’t eat out the value added by the rebalancing process. The same is true for the tax implications, but since these implications are different for any investor, we can’t give any best practice advice here. That said, professional/institutional investors and index vendors often use quarterly, semi-annual, or annual rebalancing periods.
Nevertheless, investors who build their portfolio with a saving plan or allocate any other kind of regular/non-regular cash contributions to their portfolio might not need to sell the portfolio constituents with an overweight compared to their target allocation. This is because these investors might be able to use their cash contributions to buy the securities with an underweighting compared to the target allocation to align their portfolio with their investment targets.
With regard to this, it can be concluded that the optimal rebalancing frequency depends on the personal risk tolerance and preferences of the investor, the asset mix of the portfolio, transaction costs, and tax considerations. More generally, it can be said that investors should check their portfolios at least once a year to ensure that their portfolio composition and the results of their investments are in-line with their investment targets and their strategic asset allocation thresholds.
This article is for information purposes only and does not constitute any investment advice.
The views expressed are the views of the author, not necessarily those of Lipper or LSEG.
