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Rebalancing An Investment Portfolio


When an investor starts out with his investment portfolio, the portfolio is constructed based on his objectives and risk profile. However, as time goes by, the value of the assets in the portfolio will change and some of the assets will perform better than others. Therefore, even if the investor has done nothing to his portfolio, with the market force, the better performing assets will slowly dominate over the weaker ones, causing the proportion of the assets in the portfolio to deviate from the original portfolio mix.


What is rebalancing?


Rebalancing is basically the process of restoring the asset mix in the investment portfolio back to its original target allocation in order to control the risk profile of the investment portfolio. It may sound illogical to sell the asset when it is increasing in value but one must remember that there is no one asset that will stay in favor forever. The biggest danger of leaving the portfolio to the market force is the eventual shift in asset mix and risk profile will defeat the purpose of constructing an investment portfolio, which is to diversify in order to minimize risk and achieve the return that is required.


For example, an investor has RM100,000 and he decides to invest RM40,000 in equity, RM40,000 in bond funds and RM20,000 in cash equivalents (time deposits). During the year, the price of the equity that he invested in has increased while the bond fund price has gone the other way. If he has done nothing, at the end of the year, he will be realizing a gain of 14.6%. Now that the value of equity has increased significantly, the weightage of this asset class in the overall portfolio has also increased from 40% to 49%.


Seeing this, most people will tend to leave the portfolio holding as it is or even sell off the loser to further invest in the winner thinking that the good performance will continue on or get even better. Over the next year, equity sector has turned sour, losing 30% of its value while the bond fund gains traction, increasing by 15% for the year. Now let’s look at the portfolio again. Due to the loss of value in equity, the gain obtained in year 1 has almost been wiped off, leaving only 2% return after 2 years.



However, if the investor has rebalanced his portfolio back to the original asset mix at the end of year 1, the total gain for the portfolio would have been 4% after 2 years.



How often to rebalance?


Now that we know the importance of restoring the investment portfolio asset mix back to its original mix, in order to steer a portfolio’s asset mix back to its target asset allocation and acquire risk-return characteristics that is consistent with an investor’s goals and preferences, the next step is to determine the frequency of reviewing and rebalancing the portfolio.


Theoretically, the asset mix should be adjusted as and when it has drifted away from its original mix. However, in reality, every time a transaction is made, either buy or sell, it involves cost. Therefore, the frequency of monitoring and rebalancing the portfolio will have to be balanced in between the risk of portfolio deviation and the transaction cost involved.


In general, for most diversified investment portfolios, the approach of annual or semiannual monitoring, with a rebalancing threshold of ± 5% thresholds, is commonly adopted by most investors.


Having said all the above, when it comes to an actual rebalancing exercise, some investors find it difficult to implement as it is against the natural emotions of the investors to sell off the performing assets during the bull market and invest in the underperforming assets. Therefore, it involves great discipline on the investors to remind themselves of their original investment objectives and risk profile of their investment portfolios. 


Ooi Kok Hwa
CFA, CM & AA, MA (Finance), B.Sc (Actuarial Science)
Managing Partner of MRR Consulting