Over time, as different asset classes produce different returns, the portfolio’s asset allocation changes. To recapture the portfolio’s original risk and return characteristics, the portfolio must be rebalanced to its original asset allocation. The primary purpose of rebalancing is to maintain a consistent risk profile. Periodic rebalancing will help avoid counterproductive temptations in the market. For example, in this seemingly falling market, rather than be tempted to follow the crowd, who are busy dumping popular stocks, the imbalance created by erosion of the equity component can be used by to book profits on debt portion and buy into equities to bring back the allocation to the original ratio.
The balancing act
To get all the asset classes back to their original allocation percentages would entail the following:
Selling part of the debt or cash and investing the proceeds into equities or vice versa Putting in fresh one-time investments into equity/debt to raise their percentages in the portfolio Start a systematic investment plan / value average to counter the volatile market.
How often should one rebalance?
Though the frequency is entirely dependent on the investor, the portfolio size as well as market conditions will impact the overall returns’ expectation of the portfolio. The main idea is that the periodic interval between successive rebalancing acts should be constant. Some of the other factors affecting rebalancing are:
Cost of transactions
If one decides to rebalance the portfolio once in six months, he needs to factor in short term capital gains, brokerages and entry exit loads. Hence it is advisable to rebalance once a year for long term portfolios and half yearly rebalance for short term portfolios.
Correlation
High correlation among the returns of asset classes means that they tend to move together. When the returns of all the assets in the portfolio move in the same direction, the asset allocation weights tend to remain unchanged, reducing both the risk of significant deviation from the target allocation and the need to rebalance.
Volatility
High return volatility increases the fluctuation of the asset class weights around the target allocation and increases the risk of significant deviation from the target. Greater volatility implies a greater need to rebalance. In the presence of time-varying volatility, rebalancing occurs more often when volatility rises.
The balancing act
To get all the asset classes back to their original allocation percentages would entail the following:
Selling part of the debt or cash and investing the proceeds into equities or vice versa Putting in fresh one-time investments into equity/debt to raise their percentages in the portfolio Start a systematic investment plan / value average to counter the volatile market.
How often should one rebalance?
Though the frequency is entirely dependent on the investor, the portfolio size as well as market conditions will impact the overall returns’ expectation of the portfolio. The main idea is that the periodic interval between successive rebalancing acts should be constant. Some of the other factors affecting rebalancing are:
Cost of transactions
If one decides to rebalance the portfolio once in six months, he needs to factor in short term capital gains, brokerages and entry exit loads. Hence it is advisable to rebalance once a year for long term portfolios and half yearly rebalance for short term portfolios.
Correlation
High correlation among the returns of asset classes means that they tend to move together. When the returns of all the assets in the portfolio move in the same direction, the asset allocation weights tend to remain unchanged, reducing both the risk of significant deviation from the target allocation and the need to rebalance.
Volatility
High return volatility increases the fluctuation of the asset class weights around the target allocation and increases the risk of significant deviation from the target. Greater volatility implies a greater need to rebalance. In the presence of time-varying volatility, rebalancing occurs more often when volatility rises.
