By the end of this lesson you understand why a portfolio is rebalanced and why rebalancing isn't the same as deciding a new asset allocation.
\nModule 1 introduced asset allocation: the decision of what percentage of a portfolio goes to each asset class. Over time, different assets' prices don't evolve the same way -- some rise more than others, some fall while others hold steady -- so a portfolio's actual weights gradually drift from that target allocation, even if the investor does nothing. This lesson explains why it's worth correcting that drift.
\nRebalancing is the action of bringing a portfolio's actual weights back toward its target allocation -- selling part of what has grown above its target weight, buying what has fallen below, or both. It's important to be precise about what rebalancing is and isn't: rebalancing isn't deciding a new asset allocation -- the target allocation stays the same. Rebalancing is the action of readjusting the portfolio relative to that already-decided allocation, not changing it. Changing the target allocation itself is a different decision -- for example, if the investor's risk profile or time horizon changes, already covered in Module 1 -- not something that happens from the simple passage of time.
\nWithout rebalancing, this drift has two consequences. The first is that the portfolio can drift over time toward unwanted concentration risk, already covered in Module 3: if the assets that have risen most keep accumulating more and more weight, the portfolio ends up exposed to whatever happens specifically to those few positions, more than what was originally decided. The second is that part of the benefit of diversifying, already covered in Module 2, is lost: a portfolio that has drifted a lot from its target allocation no longer spreads capital the way that was originally decided would best reduce the portfolio's overall risk.
\nA portfolio that starts with 60% in stocks and 40% in bonds can, after a period in which stocks rise much more than bonds, end up with 75% in stocks and 25% in bonds -- without the investor having made any decision. That portfolio is now riskier than originally decided. Rebalancing it means selling part of the stocks and buying bonds until returning, approximately, to the initial 60/40 -- not deciding whether 60/40 is still the right allocation.
\nRebalancing is bringing a portfolio's actual weights back toward its already-decided target allocation -- it isn't deciding a new allocation. Without rebalancing, a portfolio can drift toward unwanted concentration risk and lose part of the benefit of the diversification it was built with.
\nWhy isn't rebalancing a portfolio the same as deciding a new asset allocation?
\nWhat two consequences does never rebalancing have for a portfolio?
","sortOrder":1,"readingMinutes":7,"difficulty":"Intermedio"},"previous":null,"next":{"id":78,"moduleId":28,"slug":"how-often-and-by-what-criteria-do-you-rebalance","title":"How often and by what criteria do you rebalance?","summary":"You understand what frequency and criteria guide when to rebalance a portfolio, without it being a rigid time-based rule.","bodyMarkdown":"## Objectives\n\nBy the end of this lesson you understand what frequency and criteria guide when to rebalance a portfolio, without it being a rigid time-based rule.\n\n## Content\n\nThe previous lesson explained why to rebalance. This lesson develops when to do it -- a question with no single answer valid for every portfolio.\n\nA first criterion is periodic review: checking the portfolio at some fixed interval -- once a year, for example -- to see if its actual weights have drifted from the target allocation. It's important not to confuse reviewing periodically with automatically rebalancing at every review: reviewing simply means checking whether there's drift; rebalancing only makes sense if the observed drift justifies it. An annual review can perfectly well conclude that no change is needed.\n\nA second criterion is deviation, or threshold: instead of setting a date, you define how far an actual weight can drift from its target -- a few percentage points, for example -- before acting, and you rebalance as soon as that threshold is crossed, regardless of the date. Neither criterion is the only valid one: a periodic review with no threshold at all can let an important drift go unaddressed until the next review date, while a threshold with no periodic review to check it never gets applied in practice -- that's why, in practice, both criteria are usually combined: reviewing at some regular interval and acting only if the observed drift exceeds the set threshold.\n\nThe greater the drift an investor is willing to tolerate before acting, the greater the concentration risk that can accumulate in the portfolio in the meantime, already covered in the previous module -- the criterion for when to rebalance is directly tied to how much drift from the target allocation, and therefore how much additional risk, one is willing to accept between one correction and the next.\n\n## Example\n\nAn investor who reviews their portfolio once a year and rebalances only if some weight has drifted more than a few percentage points might, in calm years, make no change -- and in years with sharp moves, correct a notable drift. Another investor who reviews more often but tolerates a wider band before acting might end up rebalancing at a similar frequency, despite reviewing more often.\n\n## Common mistakes\n\n- Thinking rebalancing more often is always better, without considering the cost of doing so, developed in the next lesson.\n- Confusing periodically reviewing the portfolio with automatically rebalancing every time it's reviewed.\n\n## Summary\n\nThere's no single frequency or single valid criterion for rebalancing. Periodic review checks whether there's drift; the threshold criterion sets how much drift is tolerated before acting; in practice, both are usually combined. The more drift tolerated, the greater the concentration risk that can accumulate in the meantime.\n\n## Self-check\n\nWhy isn't periodically reviewing a portfolio the same as automatically rebalancing it at every review?\n\nWhy is the tolerated deviation threshold tied to the concentration risk a portfolio can accumulate?","bodyHtml":"By the end of this lesson you understand what frequency and criteria guide when to rebalance a portfolio, without it being a rigid time-based rule.
\nThe previous lesson explained why to rebalance. This lesson develops when to do it -- a question with no single answer valid for every portfolio.
\nA first criterion is periodic review: checking the portfolio at some fixed interval -- once a year, for example -- to see if its actual weights have drifted from the target allocation. It's important not to confuse reviewing periodically with automatically rebalancing at every review: reviewing simply means checking whether there's drift; rebalancing only makes sense if the observed drift justifies it. An annual review can perfectly well conclude that no change is needed.
\nA second criterion is deviation, or threshold: instead of setting a date, you define how far an actual weight can drift from its target -- a few percentage points, for example -- before acting, and you rebalance as soon as that threshold is crossed, regardless of the date. Neither criterion is the only valid one: a periodic review with no threshold at all can let an important drift go unaddressed until the next review date, while a threshold with no periodic review to check it never gets applied in practice -- that's why, in practice, both criteria are usually combined: reviewing at some regular interval and acting only if the observed drift exceeds the set threshold.
\nThe greater the drift an investor is willing to tolerate before acting, the greater the concentration risk that can accumulate in the portfolio in the meantime, already covered in the previous module -- the criterion for when to rebalance is directly tied to how much drift from the target allocation, and therefore how much additional risk, one is willing to accept between one correction and the next.
\nAn investor who reviews their portfolio once a year and rebalances only if some weight has drifted more than a few percentage points might, in calm years, make no change -- and in years with sharp moves, correct a notable drift. Another investor who reviews more often but tolerates a wider band before acting might end up rebalancing at a similar frequency, despite reviewing more often.
\nThere's no single frequency or single valid criterion for rebalancing. Periodic review checks whether there's drift; the threshold criterion sets how much drift is tolerated before acting; in practice, both are usually combined. The more drift tolerated, the greater the concentration risk that can accumulate in the meantime.
\nWhy isn't periodically reviewing a portfolio the same as automatically rebalancing it at every review?
\nWhy is the tolerated deviation threshold tied to the concentration risk a portfolio can accumulate?
","sortOrder":2,"readingMinutes":7,"difficulty":"Intermedio"},"pathContext":null,"curatedLinks":{"prerequisite":[],"continuation":[],"related":[]},"relatedConcepts":[{"concept":{"id":85,"slug":"rebalancing","term":"Rebalancing","shortDefinition":"Bringing a portfolio's actual weights back toward its target allocation when they've drifted from it -- not deciding a new allocation, but readjusting the portfolio relative to the one already decided.","longDefinition":"Rebalancing is the action of bringing a portfolio's actual weights back toward its target asset allocation, already decided in Module 1, when those weights have drifted from it -- selling part of what has grown above its target weight, buying what has fallen below, or both. It isn't deciding a new asset allocation: the target allocation stays the same, and rebalancing is the action of readjusting the portfolio relative to it, not changing it. Without rebalancing, a portfolio can drift over time toward unwanted concentration risk, already covered in Module 3, and lose part of the benefit of the diversification decided in Module 2. It involves buying and selling, which carries a transaction cost and can generate a real tax cost that must be weighed against the benefit of correcting the drift."}}]}