15 September 2022

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When and why to rebalance the portfolio

Author: Luigi Campopiano

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The saver's profile must be consistent with his objectives. Still, the portfolio distribution does not have to remain the same forever: changing the portfolio allocation happens in the practice of financial advice quite often, even if the criteria for deciding how and when do not respect universal rules. When to rebalance? Obviously, "it depends on the customer," even if rebalancing can be scheduled on a time basis (quarterly, half-yearly, or yearly). Each approach seems to have its advantages; let's see them in order: 

• The quarterly rebalancing can evaluate the portfolio more precisely on the basis of market performance (it can be useful in periods of high volatility or when the markets push hard in one direction). Suppose a particular asset class, for example, deviates significantly from the objective established with the customer. In that case, it can be corrected in the "course of work" and in a relatively short time. Finally, it will be possible to confront the client at shorter intervals on his objectives; 

• Extending the rebalancing time horizon to one year reduces the frequency of interventions and the possible negative implications of transaction and tax costs (frequent rebalancing can increase the burden on capital gains). It is a question of market timing that can determine whether a quarterly or annual rebalancing is more convenient. Depending on the case, a more frequent rebalancing could cause a bull market to liquidate early or fix the losses of a bear market. A Vanguard study based on data collected between 1926 and 2015 showed that there were no significant differences between the two approaches, except that the annual rebalancing had shown slightly lower volatility; 

• "Threshold" system. The portfolio allocation is changed only when the balance between the various asset classes exceeds certain limits: should the changes prove to be more contained, the portfolio would be left as it is. This approach requires more explanation from the client since his understanding is less immediate than a simple time frame. The "tolerance threshold" must be carefully calibrated, also based on the number of asset classes in the portfolio;

• "Constant-proportion portfolio insurance" (Cppi). It is the practical application of a basic principle of risk management: the more the wealth accumulated by the investor increases, the more he will be able to tolerate losses, with the possibility of increasing particularly volatile assets. The client's financial situation will decide how to review the allocation: if it improves, more risk may be introduced into the portfolio (if the investor has expressed an intention to take advantage of the opportunity). It is one thing to be able to "afford" certain losses; another is to want to risk more to maximize the return opportunities. 

Regardless of the rebalancing approach, it is important to have a system you trust to create, review and execute trades, and to communicate any updates to customers.