Portfolio Rebalancing
Hi, hope you are doing well. Before going into the article, I must communicate I ran into this dilemma. Google’s first part of the research (all business units breakdown) ended up being 8.200 words or a 38 minutes read according to Substack.
Article
The phrase ‘portfolio rebalancing’ is extremely common in the investment world, for it refers as one of the principal policies/fields portfolio managers have to decide upon. In this article, we’ll go through its definition, interpretation and some thoughts on how could we act with the objective of maximizing return while minimizing risk.
Definition and Interpretation
“Rebalancing refers to the process of returning the values of a portfolio's asset allocations to the levels defined by an investment plan. Those levels are intended to match an investor's tolerance for risk and desire for reward.
Over time, asset allocations can change as market performance alters the values of the assets. Rebalancing involves periodically buying or selling the assets in a portfolio to regain and maintain that original, desired level of asset allocation.” Investopedia
I believe the second part is quite transparent, I’ll focus on the first one. The source here assumes that investors construct their portfolios based on their risk profile (topic discussed here). The aim of a portfolio with such objective is for the weights to correctly match both mentioned characteristics. Those would be the exact weights that would theoretically be in accordance with a person’s particular situation. When the market moves, positions’ weights in the portfolio move as well, invariably leading to a deviation from this ‘desired exposure to each asset’. This is one of the common practices among professionals, but we’ll discuss rebalancing from a broader perspective.
Thoughts
As usual, we have to first ask ourselves if it’s actually useful to rebalance a portfolio. I always try to be as impartial as possible when thinking of these topics, I intend to state both logical sides.
There are a few things in favor of rebalancing. Mainly, periodically (monthly, quarterly, daily, yearly) rebalancing a portfolio ensures that the owner is in complete comfort and calm (allegedly). Secondly, it removes emotions from the process. Rebalancing goes in line with the investment plan designed (in a rational state) and setting it in advance makes your future self avoid acting based on momentary irrationality.
To the contrary, rebalancing also counts with some disadvantages I notice. Winners will continuously tend to exceed the threshold established and rebalancing would imply us to sell that excess and add it to companies that have gone below their desired weight. Consequently, in many scenarios, it can turn to a potential “trimming winners and adding to losers” strategy. Rebalancing assumes the weights established are ideal, because one would implicitly be reallocating capital based on these arbitrarily selected weights, leaving no room for mistakes in the weight selection process.
It's important to keep in mind most (I think) professional portfolio managers include in their portfolio several asset classes (bonds, stocks, currencies, etc). They also, in most occasions, build clients’ portfolios by assigning weights to each particular asset class and get exposure to it through diversified vehicles. The weight assignment is done with a particular ‘risk objective’ (standard deviation objective). If the investment policy agreed by portfolio manager and client establishes this risk objective, it’s appropriate for PMs to rebalance portfolios.
Since most portfolio managers follow an asset (in the actual sense) allocation approach, it seems correct for them to rebalance. They do not have intrinsic or fundamental single position risk. However, if an investor has a portfolio fully built with equities, he/she does have a unique position risk (not under volatility parameters). This risk literally depends on the fundamentals of the different and unique companies. By rebalancing, we would be de-estimating such intrinsic characteristics.
How to do it
If rebalancing is your call, it can be done in different ways:
You have to define the periodicity in which you intend to rebalance. It’s up to you, from daily to yearly. Be careful with the operation costs you’d incur.
Establishing bands. An investor can also determine what could be the potential threshold (to the upside or downside) that would trigger a rebalancing of such position.
Et cetera. Those are kind of the most common approaches. Up from that, an investor is in charge of putting all odds in favor of his portfolio performing well and all decisions should (in my opinion) harmonically flow in that direction. He/she can iterate the process of rebalancing until that point is perceived as reached.
Personal Commentary
Opposite to most articles, I felt much more biased on my arguments. Nonetheless, the things rebalancing have in favor are objectively very good, so keep that in mind. I also have many doubts on this topic, which may have clouded my judgement. Anyway, hope you enjoyed today’s issue.
On other news, I finished the first part of Google’s research and will publish it on Wednesday I believe. This first part will include a complete breakdown of all Google business units. Feel free to subscribe if you’d like to receive it!
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Twitter: Giuliano_Mana
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