Our series of WealthTech Cookbook articles explores various wealth-management components, explaining the importance of each.

In the previous part, we offered you an overview of the most popular rebalancing software on the market. Today we are covering the rebalancing concept, since the right blend of asset classes is essential to manage risk and perks to get long-term benefits.

Thus, rebalancing investment vehicles is a crucial strategy if you want to find balance between risk and returns.

Reasons why everyone should rebalance

To begin with, it’s not just a good strategy but a necessity to rebalance if you want to maintain a healthy risk-and-return balance. Rebalancing helps to:

  • Manage risk inside your portfolio, effectively removing guesswork;
  • Utilize buy-low and sell-high opportunities without emotion, using pure strategy;
  • Maintain a standard deviation (risk tolerance) aligned with the investment goals.

How do you deal with the risk-management part? By reducing underweighting or overweighting assets in a particular portfolio you can manage risk, taking into account the tendency of portfolios to become riskier with time if not rebalanced.

Usually, equities or companies’ stock (ETFs) prices tend to grow more often than, for example, the price of fixed-income assets such as corporate or government bonds, or bond mutual funds. And if ETFs rise, they do so to a greater extent compared to bonds.

Market movements can offer a chance to buy certain securities when they are underweighted and sell when they’re overweight. It all comes down to this: buy something cheap, keep it, and sell it when the price goes up, making a profit that can be used on purchasing something else that has a low price at that moment. To guarantee success in this trade, the whole journey has to begin with a diversified portfolio of investment vehicles. a diversified portfolio is the goal of the whole rebalancing practice.

What’s more, securities need to have dissimilar price movements (different categories of equities) so the investor doesn’t have all their eggs in one basket. In other words, category 1 might be declining while category 2 is going up and category 3 remains stable; this condition A plus condition B rebalancing is necessary to maintain risk tolerance and earn money.

Portfolio construction and rebalancing basics

Before we go any further, let’s look at some fundamental terms and methods to estimate the figures therein:

Compound annual growth rate (CAGR), or annualized return: The amount of money made by an investment over a period of time if the annual return is compounded. This is a geometric average that is calculated as:

Annualized return

where

r1, r2 … rn is the respective annual returns for year 1, year 2 … year n

and n is the number of years an investment has been kept in, e.g., a mutual fund.

Let’s say we have a security that has the following five-year annual returns:

Year 1: 5.0%

Year 2: 3.5%

Year 3: 8.5%

Year 4: 6.0%

Year 5: 4.0%

We can calculate the annualized total return, which is again geometric (not arithmetic), as follows:

Annualized Return

Standard deviation: A measure of the dispersion of a set of data from its standard. The formula is the square root of variance. Consider the following scenario: you have a security that grew during a five-year period, giving you returns of:

5.0% during year 1,

3.5% during year 2,

8.5% during year 3,

6.0% during year 4,

and 4.0% during year 5.

First, you need to calculate the average annual growth of this security. In our case, it’s

Second, you need to subtract each year’s growth from this average and then square those numbers:

annual growth

Third, you need to find the sum of all the squared differences:

average annual growth

and divide this by the number of years the investment was held -1, which in the current case is 5 – 1 = 4, so

average annual growth

The last step is to find the square root of this number, which is

Standard deviation

The higher the dispersion, the riskier it is to invest in that particular security. Imagine you had to choose to buy one of two securities—the one we’ve just covered and another with a similar annualized return of 5.4%:

Standard deviation

By determining the standard deviation for security 2, you can make an informed decision on which of the two securities to add to your portfolio.

Standard deviation

The comparison shows that security 1 is more volatile than security 2, although they have identical values in terms of annualized return.

Along with annualized total return, the standard deviation indicates the historical volatility of a security.

For example, two stocks with the same average return can have different standard deviations, indicating which investment option to go for.

For instance, the stocks of domestic companies are believed to be more stable compared to international ones, but adding a pinch of international shares to a portfolio does work some magic (as per modern portfolio theory described by H. Markowitz):

Historical index data for 1973–2013
Historical index data for 1973–2013
Source: https://youtu.be/0RTV8VdavqU

In the above, by investing 30% in major international equity markets (Europe, Australia, and the Middle East), we don’t increase the return of the portfolio much but we do reduce the risk. Then, by diversifying our portfolio even more and buying 10% of a third type of investment vehicle, we add an even riskier asset class—small overseas companies. However, after the last manipulation, both our returns and risk levels change significantly, turning odds in benefits.

How does rebalancing work?

Rebalancing is a way to readjust the weightings of a portfolio through periodic reviews undertaken to maintain the original risk–return preference. In other words, imagine that you have invested in corporate bonds and local and international stocks in proportions equal to 50%, 30%, and 20%, respectively, such that today your $100,000 capital is distributed among various securities as follows:

$100,000 X 50% = $50,000 in corporate bonds,

$100,000 X 30% = $30,000 in US companies,

$100,000 X 20% = $20,000 in international companies.

This is the perfect picture:

Balanced portfolio

At the year end the market climate changed, and so did your portfolio: it appreciated in value and became worth $110,000. Among the three categories of securities you had, bonds became worth $57,500 and local stocks $36,000, and the prices of international stocks dropped.

balanced vs non-balanced

This means that you need to distribute investments back to the initial ratio in the portfolio by selling, as follows:

non-balanced vs balanced

balanced vs non-balanced

Some bonds = $57,500 – $55,000 = $2,500, so their share becomes 50% again;

some local stocks = $36,000 – $33,000 = $3,000, so their share goes back to 30%; and you buy 5% more international shares with the money you made selling bonds and local stocks. In this case, the slice of international stocks returns to 20%. For example, $110 is the price of the international share you want to buy to make up for your drift in this category. The 5% shortage can be calculated as $5,500, which means that you’d need $5,500 / $110 per share = 50 additional shares to purchase.

By doing so, you keep your portfolio volatility consistent with the original intent and restore the portfolio balance.

Rebalancing

Rebelancing Betterment

Rebalancing with contributions

Typically, additional cash is added to the portfolio periodically (monthly, for example) based on the thought that some percentage of personal income (suggested value is not less than 10%) should be invested.

This technique is especially useful for investors with relatively small portfolios, since by adding cash regularly they keep their wealth from being swept away by high trading costs. In this way, an influx goes directly into underperforming assets and helps align these with the necessary asset allocation strategy.

Let’s go back to the $100,000 portfolio distributed among corporate bonds and local and international equity. Remember that after your stakes grew, the new value of your portfolio became $110,000 and the weights drifted from the initial strategy, becoming 52% in corporate bonds, 33% in local equity, and 15% in international equity.

Rebalancing with contributions

Now you add $5,000, making the portfolio worth $115,000—but what assets should you buy? Let’s start with some assumptions about how the portfolio will look after you infuse some cash into it. First, let’s work on corporate bonds: the 50% that belongs to this category should amount to $115,000 x 50% = $57,500, but there’s already $57,500 in the nonrebalanced portfolio you had by the end of the year. Thus, you can leave this investment vehicle as it is.

Moving forward, 30% of local stocks should be $115,000 x 30% = $34,500. As of now, you have in this basket $36,000, which is $1,500 more than is needed for the perfect picture. So you sell part of your local stocks.

Last, the ideal share of international bonds can be calculated as $115,000 x 20% = $23,000. Since you currently only have $16,500, you are missing $6,500 ($23,000 – $16,500) from that category of securities. Now you bring into play (a) the money you made from selling your excess local shares, and (b) the influx of $5,000 you put into making your portfolio worth $115,000 (instead of its year-end value of $110,000).

Rebalancing with contributions

Assume you decided to buy a $100 package of shares: $6500 / $100 per share = 65 additional shares bought to restore the balance.

Order list for rebalancing

The key to automated rebalancing is to generate a list of orders and then execute them automatically. Think about this for a moment: whether the need for rebalancing arises due to time or threshold reasons, the program will suggest which stocks to buy to bring it up to the value of depreciated stock and thus bring the weights back to normal.

Let’s say that after a while you see that the value of corporate bonds grew. On the one hand, you’d need to sell 17 shares of Company XYZ to bring the percentage of this particular investment vehicle back to 50% (instead of the 52% you have after the hike). On the other hand, the value of international stocks sank by 5% and the robo-component of the rebalancing software estimated that you need 52 more shares of Company QWE to balance this category back to the original 20%. So what does all this mean? The rebalancing software calculates what to buy and what to sell, taking into account real-time market data with current prices for stocks you’re keen on and the cost of the transaction.

order list for rebalancing

How often should you rebalance?

Above, we gave an example in which periodic rebalancing = client-level rebalancing when readjustment of the portfolio ratio is done on an annual basis.

Another way to look at asset allocation and rebalancing practices and monitor the performance at portfolio level is to apply the threshold rebalancing technique. In this example, you would conduct quarterly portfolio health check-ups to make sure that the allocated funds stay within 5% of the target ratios.

This means that the best-case scenario is to have 50% in bonds, 30% in local stocks, and 20% in international companies. At the same time, you would need to consider portfolio drift, which happens when asset categories have different intermittent rates of return, such that, after a while, weightings are likely to alter from initial target allocations—which is why it’s crucial to bear this drift in mind.

Taking into account an acceptable drift of 5%, you can tolerate the following ratios of the respective investment vehicles before you pull the trigger and rebalance:

Rebalancing

portfolio performance

You should think about the following when taking a close-up look at the quarterly portfolio performance:

FY17Q1: As a best-case scenario, the start of the journey uses the recommended 50/30/20 ratio of asset allocation.

FY17Q2: Your stakes grew by $5,000, with

  • bonds equating to $7,000 and constituting 54% of your portfolio, which is within the 45–55% you have decided to accept;
  • an increase in local US stocks of $5,000, equating to 33% of your portfolio, which is within the acceptable 25–35%; and
  • depreciation, and a consequential drop from $20,000 to $13,000, in the last category, meaning that this slice is only 12% rather than the acceptable threshold of not less than 15% and not more than 15%.

The above means that you need to sell either part of your bonds or part of your local stocks and buy additional shares of international companies.

To decide which category to reduce—bonds, local stocks, or some of each—you can weigh the options using the method described in the Portfolio construction and rebalancing basics section of this article.

Bottom line

We have just described the ABCs of rebalancing. However, there are other factors to take into account when adjusting a portfolio. These include:

  1. the fact of securities being recently traded,
  2. allocating more assets to the portfolio or distributing funds systematically (credit of dividends at the end of the year),
  3. tax consequences.

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