Rebalancing

Rebalancing is the process of realigning the weights of the assets in a portfolio back to their target allocation. This is typically done to manage risk and ensure that the portfolio aligns with the investor’s investment strategy over time.

Understanding Rebalancing

Rebalancing involves periodically buying or selling assets in a portfolio to maintain a desired level of asset allocation. This process is vital as market fluctuations can lead to drift from the original asset allocation, resulting in unintended risk exposure.

Key Points About Rebalancing

• Purpose: To maintain the intended risk level and investment strategy.
• Frequency: Can be done on a set schedule (e.g., quarterly, annually) or based on specific triggers (e.g., if an asset class diverges from its target allocation by a set percentage).
• Costs: May incur transaction fees or tax implications, especially if done frequently.

Example of Rebalancing

Suppose an investor has a portfolio with the following target allocations:
– 60% in Stocks
– 40% in Bonds

After a year, due to a market surge, the portfolio values have changed to:
– Stocks: $120,000 (now representing 75% of the portfolio)
– Bonds: $40,000 (now representing 25% of the portfolio)

The total portfolio value is now $160,000.

Current Portfolio Allocation

To find out the current allocations:
– Stocks: $120,000 / $160,000 = 0.75 or 75%
– Bonds: $40,000 / $160,000 = 0.25 or 25%

Rebalance the Portfolio

The target allocation is still:
– Stocks: 60%
– Bonds: 40%

To rebalance the portfolio:
1. Determine the target dollar amounts based on the new total portfolio value ($160,000):
– Target Stocks: 60% of $160,000 = $96,000
– Target Bonds: 40% of $160,000 = $64,000

2. Calculate how much needs to be sold or bought:
– For Stocks: $120,000 – $96,000 = $24,000 (Needs to be sold)
– For Bonds: $40,000 – $64,000 = -$24,000 (Needs to be bought)

Final Steps in Rebalancing

After selling $24,000 worth of stocks, the investor can use this amount to purchase bonds, bringing the portfolio back to the desired allocation:
– Stocks after selling: $96,000
– Bonds after buying: $64,000

This process of rebalancing enables the investor to maintain the desired risk profile and investment strategy as market conditions change. Regular rebalancing can help ensure that the portfolio remains aligned with the investor’s long-term goals and risk tolerance.