Portfolio Rebalancing
Diversification builds the portfolio. Rebalancing maintains it. Without periodic adjustments, market movements can quietly change a portfolio's risk profile.
What Is Portfolio Rebalancing?
- Portfolio rebalancing is the process of periodically adjusting a portfolio back to its target asset allocation
- Over time, different assets earn different returns, causing allocations to drift from their original targets
- Rebalancing restores the investor's intended risk level
Exam Tip: Gotchas
Rebalancing is periodic, not continuous. It is triggered by a schedule or by the allocation drifting past a set threshold, not by daily market noise.
Why Allocations Drift
Example: An investor targets 60% stocks / 40% bonds.
| Event | Stocks | Bonds | Problem |
|---|---|---|---|
| Starting allocation | 60% | 40% | On target |
| After a bull market | 70% | 30% | Overweight stocks = more risk than intended |
| After rebalancing | 60% | 40% | Back on target |
- Strong stock returns cause the equity portion to grow larger than intended
- The portfolio now carries more risk than the investor originally chose
- Without rebalancing, a risk-averse investor could end up with an aggressive portfolio
Exam Tip: Gotchas
Bull markets push the equity portion above the target, which increases the portfolio's risk beyond what the investor originally chose. Expect a scenario that describes drift and asks what has happened to the investor's risk profile.
How Rebalancing Works
- Sell overweight assets (those that have grown beyond their target)
- Buy underweight assets (those that have fallen below their target)
- This enforces a natural buy low, sell high discipline; you are selling recent winners and buying recent underperformers
- Rebalancing maintains the investor's chosen risk level; it does not add new risk reduction
- It is a maintenance strategy, not a risk elimination strategy
Exam Tip: Gotchas
- Rebalancing is about maintaining risk, not reducing it. Its primary purpose is to bring a portfolio back to target allocations after market movements cause drift.
- The built-in discipline is counterintuitive: you sell winners and buy underperformers. This buy low/sell high pattern can improve long-term returns by preventing concentration in a single asset class.
Rebalancing Methods
| Method | How It Works | Advantage |
|---|---|---|
| Calendar-based | Rebalance on a set schedule (quarterly, annually) | Simple, consistent |
| Threshold-based | Rebalance when any allocation drifts beyond a set percentage (e.g., 5%) | More responsive to market moves |
Exam Tip: Gotchas
Both calendar- and threshold-based rebalancing are valid; the exam does not prefer one over the other. What matters is that the portfolio is brought back to target, not the specific trigger.
Diversification handles non-systematic risk. Rebalancing maintains the plan. But what about systematic risk, the kind that diversification cannot touch? That requires hedging.