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Portfolio managers design portfolios to accommodate specific risk preferences through particular asset allocations. This diversification of assets provides the right balance of risk and return so that you can meet your target. But what happens when the asset allocation becomes unbalanced?
Throughout the year, the market value of a given security will likely see some fluctuation. In the case that the market value of an asset drastically increases due to a significant market or economic shift, its allocated weight in a portfolio will increase above its targets. In order to maintain the target allocation or balance, portfolio managers readjust the portfolio so that it returns to its designated asset allocation. This practice is known as rebalancing.
To see how this works, consider this example: if your total portfolio of $100,000 USD target asset allocation is 60% equities and 40% bonds, and your equities holding grows 10% while your bonds holding stays flat, you’re going to have a portfolio of $106,000 USD with $66,000 USD, or 62% in equities and $40,000 USD, or 38%, in bonds. In other words, the portfolio will have a risk-and-return profile different from the original target. To once again achieve the original asset allocation, the manager responsible for this portfolio will sell some of the equities. In this example, to rebalance, the portfolio manager would sell $2,400 USD in equities and buy $2,400 USD in bonds, so that your $106,000 USD portfolio will be “rebalanced” to your 60%/40% portfolio target.
Rebalancing is important, even if the asset class is performing well because it allows an investor to stay on target with his or her original investing strategy. By staying on track through rebalancing, one can decrease his or her exposure to volatility in the market.
The problem of rebalancing too frequently is that it can reduce portfolio returns due to increased transaction costs and potentially missing upsides in the market. Conversely, rebalancing not enough exacerbates risk levels and violates discipline.
The optimal rebalancing frequency varies depending on the economic environment. Compared to the ad hoc practices and human observations used by fund managers, StashAway’s algorithm makes data-driven decisions as to when to rebalance portfolios, by monitoring your holdings daily and executing rebalancing actions when necessary.