Why rebalance?

Most newbie investors have trouble understanding why rebalancing is a valuable tool for a portfolio. It seems unintuitive on the first glance to sell investments in a portfolio that have been the winners and buy the losers. But most investment research has now come to the conclusion that rebalancing is a valuable tool that can reduce risk and enhance returns compared to a buy and hold strategy.

If that is the case, then the question comes down to this: Is there an optimal rebalancing period? Should one rebalance quarterly, or semi-yearly or yearly? There is another twist where one can just rebalance based on the threshold values on as needed basis. That is if the portfolio is off by a certain preset range, e.g. 10%, one can opt to rebalance. These are called time-based or threshold based rebalancing strategies. One can also combine the two.

Most of the available research has shown that what is important is to rebalance a portfolio and not so much the parameters like frequencies or thresholds of rebalancing. The difference between different rebalancing strategies is not that different or consistent over different data and time periods considered.

Things that an investor must keep in mind for rebalancing is to make sure to keep transactions costs under control. It is foolish to pay $10 for a trade just to rebalance because the target weight of one asset is off by $100. That kind of transactions cost is unacceptable for the long-term health of your investment portfolio. At ETFscale we have designed our rebalancing engine to keep all these facts in mind. So that our users do not have to worry about these issues.

Rebalancing serves another useful purpose in that it works against the inbuilt loss generating biases of most novice investors. When an asset class is down 10%, rather than hitting a panic button and try to sell which is what most investors do, rebalancing could actually trigger a buy depending upon the rebalancing parameters set on the portfolio. This automatic investing discipline is another huge advantage of the ETFscale rebalancing tool.

Blog tags: