Portfolio%20rebalancing

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Portfolio rebalancing
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What is rebalancing

• Portfolio rebalancing is the process of bringing
  the different asset classes back into proper
  relationship following a significant change in
  one or more.
• More simply stated, it is returning your
  portfolio to the proper mix of stocks, bonds and
  cash when they no longer conform to your plan,
  when a drift occur.

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Need for Rebalancing

• Holding a portfolio or an asset that is
  overpriced and hence inferior returns.
• Composition of a portfolio may no longer reflect
  the investors objectives
• A poorly diversified portfolio, which is riskier
  than what an investor can bear

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Need for Rebalancing

• Changes in the attitude of the investors toward
  risk
• Changes of investment goals
• Liquidity needs of the investor
• Fluctuations in stock markets provide
  opportunities for both positive and negative
  aspects.
• Changes in Monetary policy, such as changes in
  interest rates and inflation.

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Rebalancing Considerations

• Rebalance at least annually
• Minimize transaction costs and tax consequences
  by adjusting new money, not liquidating existing
  assets
• Consider using lump-sum payments

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Portfolio Rebalancing

• Rebalancing the portfolio involves
• Either changing the securities currently included
  in the portfolio
• Or altering the proportion of funds in the
  securities

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When to rebalance portfolio

• Different Strategy to decide when to Rebalance
• Periodic Rebalancing
• Threshold Rebalancing
• Range Rebalancing
• Volatility-Based Rebalancing
• Active Rebalancing

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Periodic Rebalancing

• Portfolios are reset to their target allocations
  on a fixed schedulesuch as annually, quarterly
  or monthly.
• Assets that are overweight relative to the
  long-term targets are sold, and the funds used to
  purchase underweighted assets, until the original
  allocations have been restored.
• This strategy has the virtue of simplicity, but
  can require frequent, minor adjustments.
• It is also rigid, and doesnt allow investors to
  temporarily overweight asset classes or sectors
  that are expected to outperform over the shorter
  term.

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Threshold Rebalancing.

• Portfolios are adjusted if and when a particular
  asset class deviates from its target allocation
  by more than a certain amountsay plus or minus
  five percentage points.
• So if, for example, the target for large-cap
  stocks was 60, but a market rise caused that
  share to climb above 65, stocks would be sold
  and other asset classes purchased until the
  original 60 target had been restored.
• This is obviously a more flexible rule than
  periodic rebalancing, but in volatile markets it
  can trigger a great deal of unnecessary buying
  and selling.

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Range Rebalancing

• This approach is similar to threshold
  rebalancing, except that when an asset class
  rises or falls more than the allowed amount, it
  is rebalanced back to the maximum, not the
  target, allocation.
• Suppose, for example, a portfolio has a 20
  target for small-cap stocks, plus or minus five
  percentage points, but a sudden market rise takes
  that percentage to 28.
• Stocks would be sold until the small-cap share
  had been returned to 25 not the initial 20
  allocation.

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Volatility-Based Rebalancing.

• Triggers are based on the expected volatility of
  the portfolio as a whole. When volatility rises
  above a certain predetermined threshold,
  higher-volatility asset classes are sold and
  lower-volatility asset classes are purchased.
• So, for example, excessive volatility might lead
  an investor to sell small-cap stocks a
  relatively risky asset classand buy short-term
  bondsa relatively low-volatility asset class.

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Active Rebalancing.

• Portfolios are rebalanced to the original target
  allocations as needed, based on analysis of
  expected market conditions.
• This approach is similar to tactical asset
  allocation, which seeks to exploit short-term
  market trends.
• Believe markets are not continuously efficient,
  and securities mispricing at times gives an
  opportunity for beating market.
• Practitioners believe that they can beat the
  market.
• Combines both fundamental and technical analysis
• Higher transaction cost

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FORMULA PLANS

• Based on predetermined rules that specify the
  nature, timing and proportion of change.
• Contains two portfolios aggressive and
  conservative. They differ in their volatility and
  the type of investments.
• Economic conditions and the aggressive and
  conservative portfolios.
• The prices of the two portfolios

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FORMULA PLANS

• The volatility of the aggressive portfolio
  depends on the risk tolerance of the investor.
• The aggressive portfolio can be divided among a
  number of stocks with high volatilities to
  overcome any pitfalls in the future expectations
  of the stock movements.
• Formula plans provide the highest gains if the
  stock prices move through a full cycle, a peak
  and a trough.

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Constant dollar value paln

• Such as rebalancing when the aggressive portfolio
  moves up or down by 20

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Constant dollar value paln
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Constant ratio plan

• Such as when the amount invested in each
  portfolio is equal, then revising the portfolio
  when the ratio of the aggressive portfolio to the
  conservative portfolio changes upward or downward
  from the target value of 1 by 10. So the first
  action point will be either at 1.10 or at 0.90.
  The adjustment is made so the two portfolios
  should be equal.

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Constant ratio plan
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Cost of Rebalancing

• The actual benefits of rebalancingand the
  correct choice of rebalancing strategies depend
  on many factors, some of them unique to each
  investor.
• Most individual and corporate investors, for
  example, must pay taxes. Frequent rebalancing
  could lead to the realization of substantial
  capital gains, and the taxes on these gains might
  offset any improvement in post-tax returns.

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Cost of rebalancing

• Brokerage commissions and other trading costs
  also need to be taken into account.

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Practical problems in portfolio revision

• Risk bearing ability investors may have
  difficulty in expressing their risk-tolerances in
  terms of portfolio volatility.
• Investment planning horizon the Shorter the time
  frame, the lower the probabilities of achieving
  expected returns

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The Benefits of Rebalancing your Portfolio (video)