The rebalancing of investments is the action / trading strategy of bringing a portfolio that has deviated away from one's target asset allocation back into line. This can be implemented by transferring assets, that is, selling investments of an asset class that is overweight and using the money to buy investments in a class that is underweight, but it also applies to adding or removing money from a portfolio, that is, putting new money into an underweight class, or making withdrawals from an overweight class. Rebalancing of investment is a concave trading strategy; as opposed to constant proportion portfolio insurance, which has convex payoff characteristic.
The investments in a portfolio will perform according to the market. As time goes on, a portfolio's current asset allocation will drift away from an investor's original target asset allocation. If left unadjusted, the portfolio will either become too risky, or too conservative. If it becomes too risky, that will tend to increase long-term returns, which is desirable. But when the excessive risks show up in the short term, the investor might have a tendency to do the worst possible thing at the worst possible time, thus dramatically diminishing their ending wealth. If the portfolio is allowed to drift to a too conservative status, then excessive short-term risk is less likely, which is desirable. However, long-term returns would also tend to be lower than desired. It is best to maintain a portfolio's risk profile reasonably close to an investor's level of risk tolerance. The goal of rebalancing is to move the current asset allocation back in line to the originally planned asset allocation Buy-and-Hold, 2) Constant-Proportion and 3) Option-Based Portfolio Insurance.
Rebalancing bonus
The promise of higher returns from rebalancing to a static asset allocation was introduced by William J. Bernstein in 1996. It has since been shown to only exist under certain situations that investors are not able to predict. At other times rebalancing can reduce returns. Most agree that:
A potential rebalancing bonus is determined by two assets' relative variances and covariance. These metrics are developed by averaging historical returns, which are no guarantee of future results in the short term or long term. E.g. debt is traditionally thought to be negatively correlated to equities, but during the 'Great Moderation' they were positively correlated.
The bonus would be maximized by a 50:50 weighting between the two assets. But that is not to say any particular portfolio should have that weighting.
The bonus is greater when each asset's price swings widely, so that each rebalancing creates an entry point at a very low cost relative to the trend. But that is not to say price volatility is a desirable attribute of any asset.
The bonus is greater when the prices of both assets are increasing at roughly the same trend rate of return. If one asset's growth is much lower, each rebalancing would push money from the winning asset into the losing asset.
The bonus is greater when returns are negatively correlated and revert to their mean on the same cycle as the rebalancing takes place.
The Constant-Mix rebalancing strategy will outperform all other strategies in oscillating markets. The Buy-and-Hold rebalancing strategy will outperform in up-trending markets.
Some say that the exact choice is probably not too important, as long as the rebalancing is performed consistently. Some say otherwise, such as:
Rebalancing every year:
Rebalancing every 15 months:
Rebalancing when current allocation is 5% off from target asset allocation:
Rebalance using contributions or withdrawals:
Also
Rebalance Symmetrically whereby allocations across assets or asset categories are traded back to target.
Rebalance Asymmetrically whereby allocations are only traded where Assets or categories breach tolerances around a target - this is a Transaction Cost Sensitive approach.
