Financial Education

Portfolio rebalancing requires a trade-off between the cost of rebalancing and the cost of not rebalancing. Costs of rebalancing include trading costs and taxes, which must be weighed against:

• the reduction in expected portfolio value resulting from suboptimal asset allocation
• exposure to greater risk as the riskier assets typically earn more and become a larger percentage of the portfolio
• shifting risk factors as asset weights change
• using rebalancing to reduce exposure to the assets that have risen most and may be overvalued

To reflect this trade-off, rebalancing is typically performed in a disciplined fashion, based either on the calendar or on tolerance corridors.

Calendar rebalancing takes place at specific times, and as such does not require constant monitoring. However, it is insensitive to market conditions and may allow weights to drift substantially between rebalancings.

Tolerance corridors call for rebalancing whenever an asset class drifts out of proportion to a pre-specified range around the target weight. It allows tighter control as it is directly related to market performance, but also requires continuous monitoring.

For more information, see all articles on: Active Management, Asset Allocation, FInancial Planning, Investment Returns, Passive Management, Portfolio Management, Risk Management

See also:

Portfolio Rebalancing: Setting Optimal Asset Class Target Corridors

Portfolio Monitoring and Rebalancing

The Portfolio Management Process

Immunization Strategies for Fixed Income Portfolios

The Role of Derivatives in Rebalancing