An effective long-term investment strategy focuses on asset allocation across products and asset classes keeping in mind the risk-return needs of an investor. This also helps counter market volatility. Over time with change in asset prices and asset returns, a portfolio’s asset allocation changes and gives rise to the need for rebalancing. Here are two basic ways through which you can rebalance.
Periodic, time-based rebalancing
For investors, who don’t actively track asset prices, it is best to adopt a periodic and systematic approach. You set the frequency for portfolio reviews and rebalance accordingly. You need not rebalance with every review unless one of two things happen—either the allocation for specific assets has deviated substantially say in excess of 10% or your original goals and requirements have changed and warrant a change in allocation. In this strategy, the rebalancing trigger can also be a fixed deviation, say 5% or 10%, from the original allocation consistently over a period of time.
The frequency will depend on asset characteristics. So if you have 80% equity in your portfolio, the review frequency is likely to be at shorter intervals. But if 80% of it is in fixed-return assets, it’s better to space the review cycles.
This works better for active investors, who keenly follow asset prices. Although the risk-return pattern of a portfolio is best viewed in line with the asset allocation, often absolute returns or risk can cloud judgment. For example, a sharp fall in equity markets for some (risk-taking investors) may create an opportunity to buy at cheap valuations and for others (risk-averse investors) the panic to sell. This happens despite knowing that the equity part is meant for long-term goals, which don’t change often, and that short-term volatility in equity gets evened out over time.
This type of rebalancing relies more on the market environment and external dynamics that affect asset prices. Given that in the recent years, price volatility across asset classes has increased, there is some merit in adopting this strategy, but the risk involved is higher as the rebalancing is based on external events rather than your financial goals and risk appetite.
Other criteria you should consider
Consider other factors such as cost of entry and exit into products and their tax treatment. Frequent rebalancing will result in higher transaction costs and eat into overall returns. Also, rake in interest income and dividends while considering rebalancing.
What works for you?
Whether you choose periodic or tactical (this can be done while following periodic rebalancing), rebalancing will depend on your individual risk-return requirements. Mostly, periodic rebalancing is seen as an appropriate approach and specifics such as price trigger can be adjusted according to individual portfolios.