Different Types of Portfolio Rebalancing Strategies

Successful investing is about more than just good choices. Real, long-term success comes from understanding the art of portfolio maintenance. Proper portfolio rebalancing aims to adjust your asset allocation based on current performance and goals. Here are common strategies that you can use to keep your investments on track.

A financial advisor can provide insights into which investment strategy is best for your portfolio.

What Is Rebalancing?

Portfolio rebalancing means adjusting the asset allocation in your investment portfolio so it stays aligned with your needs and goals. You or your account manager can rebalance the portfolio through buying or selling assets to match those goals.

Here are four common reasons why investors engage in portfolio rebalancing:

Risk management: Rebalancing helps control the level of risk in a portfolio. If one asset class becomes too dominant, it can expose the portfolio to higher levels of risk if that asset class experiences a significant downturn.
Maintain investment objectives: Rebalancing ensures that the portfolio is on track to meet the investor’s goals and risk tolerance.
Locking in profits: Rebalancing allows you to take profits from assets that have performed unexpectedly well and reinvest them in assets with more potential for growth.
Long-term strategy: It helps maintain a long-term investment strategy, preventing the portfolio from becoming overly influenced by short-term market trends.

Different Types of Portfolio Rebalancing Strategies

Each of the following rebalancing strategies depends on an investor’s risk tolerance, investment objectives, and level of involvement in managing their portfolio. Here are explanations of three types of portfolio rebalancing strategies:

Time-Based Rebalancing

Time-based rebalancing is a straightforward approach where an investor sets specific time intervals (e.g., quarterly, annually) to review and adjust their portfolio allocation.

For instance, if you use a quarterly time-based rebalancing strategy, you would review your portfolio every three months. The allocation has deviated significantly from your target (e.g., stocks now make up 70% of the portfolio), so you take steps to rebalance it back to the desired allocation.

This approach is easy to implement and provides consistent rebalancing. However, it doesn’t consider market conditions, asset performance, or investor risk tolerance. As a result, it can incur unnecessary or suboptimal trades.

Constant Proportion Portfolio Insurance

Constant Proportion Portfolio Insurance is a dynamic portfolio management strategy that combines elements of both aggressive (high risk, high return) and conservative (low risk, low return) investing. It involves allocating more to risky assets, such as stocks, when markets are performing well and shifting towards safer ones, such as bonds, when markets are declining.

This approach involves two components: the floor and the multiplier. The floor is the minimum value the portfolio should maintain to meet the investor’s objectives. It’s usually based on the investor’s risk tolerance. The multiplier is the excess value above the floor, and it determines how much of the portfolio is invested in risky assets.

For example, let’s say that you have a $120,000 portfolio, an $80,000 floor and a multiplier of 2, your allocation to equities would be 2 × (portfolio value – floor) or $80,000 at inception.

Now, let’s assume that economic turbulence affects the market, and your portfolio drops to $100,000. In response, your investment manager rebalances the stock portion with the same formula: 2 x ($100,000-$80,000). So, your stock allocation is now $40,000, shielding you from sinking stock prices.

This approach is more complex, but can help you capitalize on bull markets and dodge the worst of bear markets.

Percentage-of-Portfolio Rebalancing

Percentage-of-portfolio rebalancing means adjusting your portfolio according to a specific composition. For example, suppose you have an investment portfolio consisting of 70% stocks and 30% bonds. And you have a 5% allowable band, meaning each allocation can rise or fall up to five percentage points without needing adjusting.

Over time, due to market movements, the stocks lose value while the bonds grow in value. Within a few years, the allocation shifts to 64% stocks and 46% bonds. These values are outside the 5% band, so you rebalance the portfolio. Doing so means selling some of the bonds and buying more stocks with the proceeds to return the allocation to the original 70/30 split.

This approach allows for flexibility in portfolio management and helps investors avoid frequent trading in stable markets. However, it doesn’t take into account specific market conditions and can lead to trading that clashes with profitability. For example, if stock prices soar, the allocation restrictions can prevent you from buying more stocks.

What to Consider When Choosing a Rebalancing Strategy

When choosing a rebalancing strategy for your investment portfolio, it’s essential to consider various factors to ensure that it aligns with your financial goals, risk tolerance, and investment timeline. Here are 10 common considerations:

Risk tolerance: Understand your risk tolerance and investment horizon. Some rebalancing strategies may involve more frequent trading or exposure to higher market risk. Consider how comfortable you are with potential fluctuations in your portfolio’s value.
Investment objectives: Clearly define your investment goals, whether they are long-term wealth accumulation, retirement planning, or funding a specific financial milestone. Different goals may require different rebalancing approaches.
Asset allocation: Determine your target allocation for various asset classes (e.g., stocks, bonds, real estate). This allocation should have its basis in your risk tolerance, time horizon and financial goals.
Rebalancing frequency: Decide how often you will review and potentially adjust your portfolio. Consider factors like transaction costs, tax implications and market conditions. Common intervals include quarterly, semi-annually, or annually.
Tolerance bands or thresholds: Set specific deviation thresholds that trigger a rebalance. For example, you may rebalance if an asset class deviates by more than 5% from its target allocation.
Market conditions: Be mindful of prevailing economic conditions, interest rates and overall market trends. Some rebalancing strategies respond to market conditions, while others follow a predetermined schedule.
Tax efficiency: Consider the tax implications of rebalancing. Selling investments may lead to capital gains taxes. Strategies like tax-loss harvesting can help offset gains. In addition, holding assets for a year before selling will incur long-term capital gains, which generally receive more favorable tax rates than short-term capital gains.
Transaction costs: Factor in trading fees associated with buying and selling assets. Frequent rebalancing can lead to higher transaction fees, which erode returns.
Investment knowledge and expertise: Evaluate your level of familiarity with financial markets and investment strategies. Some approaches, like constant proportion portfolio insurance, may require a deeper understanding.
Emotional considerations: Recognize your emotional responses to market volatility. Rebalancing based on predetermined criteria can help avoid impulsive decisions during turbulent market periods.

How to Rebalance a Portfolio

Rebalancing a portfolio involves bringing the current allocation of assets back in line with your preferred strategy. Here are three common steps to help you do it:

Evaluate Current Holdings

Start by examining your existing portfolio to understand the current allocation of assets. You’ll be able to see or calculate the percentage of stocks, bonds and any other asset classes in your portfolio. For example, if you have $100,000 invested with $60,000 in stocks and $40,000 in bonds, the allocation is 60% stocks and 40% bonds.

Designate the Desired Allocation

Decide on the ideal allocation for each asset class. Generally, doing so means returning to your initial portfolio composition, although you may also change due to market conditions or a new risk tolerance. The goal is to ensure that the desired allocation reflects your investment objectives and asset preferences.

Use Cash Flow to Rebalance

If you’re consistently adding new money to your portfolio (e.g., through regular contributions to a retirement account), you can use these funds to rebalance. Allocate new contributions to the underweighted asset classes to bring them back in line with your desired allocation. In addition, you can sell assets for additional revenue to reinvest. Be mindful of any tax implications when using cash flow to rebalance.

Rebalancing in Tax-Advantaged vs. Taxable Accounts

Where you rebalance your portfolio can have a major impact on your tax bill. This is why it’s important to know the difference between tax-advantaged and taxable accounts when it comes to managing your investments.

Tax-advantaged accounts, such as traditional IRAs, Roth IRAs and 401(k)s, allow you to buy and sell investments without triggering capital gains taxes. This makes them an ideal place to perform portfolio rebalancing, since you can adjust your allocation as needed without worrying about tax consequences.

In contrast, taxable brokerage accounts are subject to capital gains taxes whenever you sell appreciated assets. If you’ve held an asset for more than a year, the gain is taxed at the long-term capital gains rate; for assets held less than a year, the short-term rate applies, which is typically higher.

To minimize your tax burden, consider prioritizing rebalancing within tax-advantaged accounts first. For taxable accounts, you might use new contributions or dividends to buy underweighted assets rather than selling overperforming ones. This method helps bring your portfolio back in line without incurring unnecessary taxes.

By strategically choosing where to rebalance, you can help preserve more of your investment gains and improve your portfolio’s long-term efficiency.

Bottom Line

A financial advisor reviews different portfolio rebalancing strategies with a client.

Portfolio rebalancing is a crucial aspect of any investment strategy. It ensures your portfolio remains in sync with your risk tolerance, investment goals and market conditions. The chosen rebalancing strategy, whether time-based, CPPI or percentage-of-portfolio, should be based on your individual circumstances. Ultimately, a well-thought-out rebalancing strategy, coupled with prudent decision-making, can significantly contribute to the long-term success of your investment portfolio.

Tips on Rebalancing Your Portfolio

Rebalancing your portfolio can demand constant vigilance and expertise, especially if you want to implement Constant Proportion Portfolio Insurance. A financial advisor can ensure your portfolio is in top shape at all times. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
SmartAsset’s asset allocation calculator can project returns based on different rebalancing strategies.