Portfolio Rebalancing and Weighting Strategies
Portfolio rebalancing and weighting are powerful risk management strategies every investor should employ. This is universal for every investor, but especially relevant for the value investor.
What is Portfolio Weighting?
An assets percentage of a portfolio is its portfolio weighting. As a part of investment allocation an investor should measure the portfolio weighting for an asset class, category, sector, individual stock, etc. The calculation for portfolio weighting is determined by dividing the current value of the asset(s) by the total value of the portfolio.
What is Portfolio Rebalancing?
Portfolio rebalancing is the act of buying and selling assets to achieve your desired weighting in each asset. This is particularly important when considering your asset allocation to asset classes (i.e. stocks, bonds, cash, etc).
Portfolio rebalancing might be required because of a change in asset prices or because you desire to change your target asset allocation (reweighting).
Rebalancing and Reweighing Strategies
Portfolio weighting should be determined by the amount of confidence you have in the asset. The largest factor for a value investor would be the price or valuation of the asset(s). Assets priced with the largest margin of safety would have the largest weightings.
Rebalance Because of a Change in Asset Prices
Over time, as a portfolio’s assets change in price it can easily move the portfolio to a position that risk and return become inconsistent with an investor’s goal and risk preferences. As some assets increase in weighting they make up a larger percentage of the portfolio; at the same time, the declining assets weighting falls and becomes a smaller percentage of the portfolio. If an investor does not rebalance the portfolio it will gradually move to high return and higher risk investments.
Portfolio rebalancing forces an investor to buy low and sell high. For example, let’s say you have a target asset allocation of 40% for asset category A and a target asset allocation of 40% for asset category B. Then let’s assume asset A increases 50% and asset B declines by 50%. Now you own 3 times as much of asset A compared to asset B because asset A has increased to 60% of the portfolio and asset B has declined to 20% of the portfolio.
After these fluctuations, not only is your asset allocation out of balance, but now you own more of an asset or category that has just risen 50% and may be overvalued, and own less of an asset or category that may be undervalued. Rebalancing allows an investor to sell overvalued assets and buy undervalue assets.
Change Your Desired Target Asset Allocation (Reweighting)
The above example has the investor rebalancing to the prior asset allocation weighting. But what if the investor changes the target allocation to better reflect the risk of the asset because of the price change?
If an asset or category has risen substantially it may not deserve equal weighting with the asset or category that has experienced a substantial decline in price. Again, take the above example; if asset A is up 50% and asset category B has declined 50%; an investor may choose to move his target asset allocation (weighting) to reflect the relative risk and potential of each asset.
Instead of rebalancing each one to a 40% weighting, a value investor may decide that asset A, because it is now overvalued should be reduced to 30% of the portfolio, and asset B, because it is undervalued, should be 50% of the portfolio. If done correctly, the portfolio is still diversified but now has less risk and greater potential for appreciation at the same time.
Implementing a Portfolio Rebalancing and Weighting Strategy
Portfolio rebalancing and weighting is most easily implemented with a tactical asset allocation. Flexibility makes a tactical asset allocation strategy superior to a static or fixed asset allocation which would not allow an investor to make changes to there target asset allocation.
A portfolio rebalancing and weighting plan based on valuation is a powerful risk management strategy. Use this approach to lower portfolio risk and take advantage of opportunities based on price.
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While Arbor Investment Planner has used reasonable efforts to obtain information from reliable sources, we make no representations or warranties as to the accuracy, reliability, or completeness of third-party information presented herein. The sole purpose of this analysis is information. Nothing presented herein is, or is intended to constitute investment advice. Consult your financial advisor before making investment decisions.