Strategic portfolio rebalancing is the buying and selling of financial assets to restore a portfolio's target asset mix. Financial assets include stocks, bonds, derivatives, mutual funds and money-market securities. Retired individuals may prefer an asset mix weighted toward bonds because of the regular interest payments and safety of principal, while younger investors may prefer a more aggressive portfolio favoring stocks. Periodic rebalancing ensures that the mix of stocks, bonds and other assets is consistent with an investor's long-term financial plan.
A portfolio's asset mix changes when there is a difference in the market performance of different asset categories. For example, if a $100,000 investment portfolio is equally invested in stocks and bonds, the corresponding dollar values are $50,000 each. If stocks rally by 10 percent but bonds fall by 10 percent, the equity value would be $50,000 multiplied by 1.10, or $55,000, and the bond value would be $50,000 multiplied by 0.90, or $45,000. The new asset mix would be 55 percent equities and 45 percent bonds. This would change the risk-return profile of the portfolio because it is now weighted in favor of equities. Strategic portfolio rebalancing would restore the original asset mix of this portfolio to 50-50.
Rebalancing can be achieved in two basic ways. First, buying and selling assets could restore the original asset mix. Continuing with the earlier example, selling $5,000 worth of equities and buying $5,000 worth of bonds would restore the 50-50 asset mix. Second, investing additional funds to buy the asset that has fallen in value would also restore the original asset mix. In the example, investing an additional $10,000 in bonds would also restore the original 50-50 asset mix. Strategic rebalancing may also involve different assets within the same asset category. For example, if technology stocks have outperformed financial stocks, rebalancing could involve selling technology and buying financial stocks to restore the asset mix. The rebalancing frequency usually depends on a combination of the calendar and market conditions. For example, investors may review and rebalance their portfolios semi-annually and when there is at least a 10-percent change in market values.
The main advantage of strategic rebalancing is that it maintains a portfolio's investment objectives and risk profile. A related advantage is that it periodically trims potentially expensive assets in favor of undervalued assets. However, individual investors may find rebalancing expensive because of trading commissions and other transaction fees. For taxable portfolios, frequent rebalancing could also increase trigger additional capital gains taxes.
Buy-and-hold investing involves holding on to assets as long as the underlying fundamentals remain strong. Investors reduce their transaction costs but may miss profitable buying and selling opportunities. Momentum investing involves buying assets with increasing prices and selling assets with declining prices. Investors take advantage of market volatility but incur high transaction costs.
Based in Ottawa, Canada, Chirantan Basu has been writing since 1995. His work has appeared in various publications and he has performed financial editing at a Wall Street firm. Basu holds a Bachelor of Engineering from Memorial University of Newfoundland, a Master of Business Administration from the University of Ottawa and holds the Canadian Investment Manager designation from the Canadian Securities Institute.