In general, there are two types of portfolio rebalancing strategies. As you will soon see, these two types are often combined. Each strategy has its own set of pros and cons.
Periodic rebalancing is the easiest way to ensure your target asset allocation remains intact. The strategy entails choosing a defined interval for rebalancing (i.e., quarterly, semi-annually, annually) and checking to see whether your asset allocation needs to be adjusted.
Ease and simplicity are the primary benefits of periodic rebalancing. Periodic rebalancing also ensures that investors can avoid something called ‘portfolio drift,’ which exposes them to higher risk relative to their target asset allocation.
The downside to not rebalancing more frequently is not tracking your target asset allocation closely enough. Research from the American Association of Individual Investors (AAII) found that portfolios that rebalance more frequently “tracked the target asset allocation more closely.”
Tolerance Band Rebalancing
Also called percentage-of-portfolio rebalancing, this strategy involves aligning your intended asset allocation based on percentages. In other words, you would rebalance the portfolio only when your asset allocation changes by a pre-specified percentage.
For example, if your target asset allocation for stocks is 50% of your portfolio and your portfolio shifts to 55%, you would re-balance to get the intended exposure back. The percentage threshold at which you rebalance must be decided beforehand.
The advantage of this method is that it gives you the opportunity to rebalance more frequently to ensure your portfolio doesn’t suffer from too much drift. The downside is higher trading costs, especially in volatile market cycles. If you are trading more frequently based on percentages, you will likely have to pay more in trading fees and commissions.
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Combining the above-mentioned strategies using a time-and-threshold approach allows you to monitor your portfolio on a set schedule but only requires action if your percentage allocation changes by the predetermined threshold.
The strategy is advantageous because it allows you to simplify your rebalancing schedule while benefiting from the more effective percentage threshold strategy. The downside is the same as the one mentioned for tolerance band rebalancing; namely, such portfolios incur higher costs if the rebalancing time-frame is more frequent.