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ABOUT FINANCE
The Art of Rebalancing
Michael L. Brunner
Analyzing the expected performance of different asset classes
is one way investors can construct portfolios that-over the
long run-will yield the highest possible return for a given
level of risk.
The process of making periodic adjustments to an investment
portfolio in order to ensure that it remain on course with
a long-term investment strategy is known as rebalancing. Familiarizing
yourself with some of the popular portfolio rebalancing strategies
can help you understand how important periodic rebalancing
adjustments can be in helping to ensure your long-term investment
success. Consider these choices when rebalancing:
Periodic rebalancing requires
a portfolio to be reset to its target allocations on a fixed
schedule-such as monthly, quarterly or annually. This strategy
has the virtue of simplicity, but can require frequent, minor
adjustments. It can also be very rigid and doesn't allow investors
to temporarily overweight asset classes or sectors that are
expected to outperform over the shorter term.
Threshold rebalancing requires
portfolios to be adjusted if or when a particular asset class
deviates from its target allocation by more than a certain
amount-such as a specific percentage point. This strategy
is more flexible than periodic rebalancing, but in volatile
markets it can trigger unnecessary buying and selling.
Range rebalancingis similar
to threshold rebalancing, except that when an asset class
rises or falls more than the allowed amount, it is rebalanced
back to the maximum, not the target, allocation. When using
range rebalancing, investors adjust their portfolios to a
maximum deviation amount when the portfolios rise or fall
more than the allowed amount.
Volatility-based rebalancing
is based on the expected volatility of the portfolio as a
whole. When volatility rises above a certain predetermined
threshold, higher-volatility asset classes are sold and lower-volatility
asset classes are purchased.
Active rebalancing involves
the rebalancing of the portfolio to target allocations based
on an analysis of expected market conditions. This approach
is similar to "tactical" asset allocation, which
seeks to exploit short-term market trends. However, it is
more conservative than a market-timing approach because changes
in the portfolio tend to be relatively modest.
It is also important to understand the pros and cons of
rebalancing. There may be higher monetary costs, such as
commissions and tax expenses. Additionally, as more changes
are made to keep the investments on a target, the amount
of taxes may increase as well.
The primary goal of rebalancing is to help ensure that your
investments adhere to a properly diversified asset allocation
strategy. In periods of market volatility-including periods
of outperformance-rebalancing can help your investment strategy
remain on course.
For a copy of the Smith Barney
Consulting Group's white paper, The Art of Rebalancing,
contact the author at michael.l.brunner@smithbarney.com.
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