Financial markets have experienced volatility lately as investors mull over positive economic news, mixed corporate earnings, the prospect of central banks raising interest rates, and a conflict in Europe between Russia and the Ukraine.
While volatility can be unnerving, it reminds us of the importance of portfolio diversification in spreading out the potential for risk across multiple regions, industries and even company sizes.
Volatility can also remind us of the importance of rebalancing a portfolio’s long-term strategic asset allocation. This is the mix of asset classes, such as equities and fixed income, that’s consistent with an investor’s long-term investment goals. For example, if volatility causes the equities in a portfolio to decline in value and the fixed income to rise in value, then the mix would change to a lower percentage of equities and a higher percentage of fixed income.
This is where portfolio rebalancing plays a role. Rebalancing returns the portfolio to its strategic asset mix. That mix has a long-term focus and aims to ensure the portfolio maximizes the opportunity to achieve its investment goals in a manner consistent with the investor’s risk tolerance. The strategic asset mix of stocks and bonds should be based on an investor’s time horizon, the rate of return needed to meet their goals, and their comfort level with the ups and downs of the markets. Once in place, it’s important to regularly review the strategic asset mix to ensure it remains aligned with an investor’s goals and risk tolerance. Rebalancing involves periodically selling assets that have recently outperformed and buying assets that have underperformed in order to bring the portfolio back to its original mix.
The need to rebalance portfolios primarily arises from market developments. Asset prices change over time. Some markets go up or down more than others during a particular period. Price changes can cause portfolios to drift away from their strategic asset mix. This drift can introduce unintended risks into the portfolio, such as higher asset concentrations caused by a growing proportion of the portfolio in a certain asset class, which could cause higher portfolio volatility in future. Rebalancing is a disciplined way to maintain risk and diversification within an acceptable range.
In any period, we never know how far prices might drift from their underlying valuation, making it impossible to set an optimal rebalancing schedule. Instead, investors typically follow one of the following two approaches to rebalancing:
1. Regular calendar basis—quarterly or annual rebalancing, for example. If the extent of drift during a period is small, however, the investor could incur unnecessary transaction costs. The scheduled timing of calendar-based rebalancing may also coincide with a period of market stress and incur relatively high transaction costs associated with illiquidity.
2. Threshold basis—rebalancing whenever the asset mix drifts away from strategic weights by more than a predefined percentage. For instance, when the equity weighting in a traditional 60/40 portfolio (i.e. 60% equity, 40% fixed income) moves outside of a 55-65% range, rebalancing guidelines would trigger a portfolio rebalancing. Some measure of portfolio tracking error can also be used as the threshold in this approach.
