BMO Nesbitt Burns
1 First Canadian Place
38th floor, P.O. Box 150
Posted on: April 28, 2021
To ensure you remain on track with your goals and maintain your risk profile, a simple, yet powerful, strategy known as portfolio rebalancing should be applied.
Rebalancing is the process of restoring a portfolio to its target allocations by resetting the proportions of each asset class or positions back to its original state (i.e., percentage allocations).
Portfolios should be assessed to see if rebalancing is required:
- To assess if your strategy’s current asset allocation deviated from its target allocation.
- To assess if your portfolio’s overall asset mix is consistent with your target asset mix.
How does a portfolio drift from the original target allocation? Take a look at the chart below.
As the equities in this portfolio perform better than the bonds in the portfolio, the equities will rise as a percentage of the assets faster than the bonds do. In order to bring the asset allocation back to its original state, a portfolio rebalance is required.
There are several benefits to portfolio rebalancing that you should be aware of, as well as certain types of rebalancing strategies and scheduling preferences.
Rebalancing helps control portfolio risk.
Rebalancing is primarily about risk control, or making sure your portfolio isn’t overly dependent on the success or failure of one investment, asset class or investment style.
This also brings discipline to the asset allocation process.
The need to rebalance is due to the fact that asset classes will perform differently over various time periods and market conditions. Prolonged conditions causing one asset class to under or over perform may result in a greater deviation in the asset mix of a portfolio from its original allocation.
More importantly, this also results in a deviation from the original risk parameters and investment objectives. Rebalancing helps minimize exposure to market volatility by taking profits in investments that have risen and reinvesting in ones that have lagged.
When to rebalance
There are several types of rebalancing strategies, but the most common are calendar and range rebalancing, which are based on differing criteria.
In calendar rebalancing, the portfolio is rebalanced back to its target allocations on a predefined schedule, such as quarterly, semi-annually or annually. The advantage of calendar rebalancing lies in its simplicity.
Range rebalancing involves conducting regular reviews of a portfolio, but rebalancing only when the portfolio’s asset allocation has drifted from its target weights based on a set threshold. Your accounts are reviewed to determine whether any allocation has deviated from its target by a specific percentage, 5% as an example.
The true value of rebalancing
The true value of a rebalancing strategy is not measured through incremental returns for the portfolio, but rather, in the risk controls it provides to the portfolio.
Furthermore, these added controls do not have to come at the expense of sacrificing returns.
This is the point of rebalancing: You do not know what investment, asset class or style is going to outperform next year, or how rapidly things might change.
Rebalancing helps minimize exposure to market volatility by taking profits in investments that have risen, reinvesting in ones that have lagged and providing some protection from severe changes in market leadership.