Financial Education

One way to balance the costs and risks associated with portfolio rebalancing is to set target corridors for asset class weights rather than specific weights. At least five factors should be considered when setting the tolerance ranges:

1. Transaction costs – higher transaction costs should result in a wider corridor so that rebalancing occurs less frequently
2. Risk tolerance – higher risk tolerance also justifies wider corridors
3. Correlation with the rest of the portfolio – when assets move in the same direction as the rest of the portfolio they are unlikely to drift further from target weight. This, in turn, allows for a wider target corridor.
4. Asset class volatility – the more volatile the asset class, the more likely a wider divergence from the optimal weight. This requires a tighter corridor.
5. Volatility of the rest of the portfolio can also lead to large divergences from optimal weights and the need for tighter corridors.

Once a target corridor is breached, the portfolio may be rebalanced to the target weight or to some level within the target corridor. The latter methods allow for more control, particularly with regard to illiquid assets. The alignment to strategic asset allocations would be less, but transaction costs would be lower.

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

See also:

Portfolio Rebalancing: Cost/Benefit Analysis

Portfolio Monitoring and Rebalancing

When Should an Asset Class Be Included in a Portfolio?

The Role of Strategic Asset Allocation in Portfolio Management

Framework for Setting Capital Market Expectations