Portfolio Rebalancing in Theory and Practice

Abstract

A portfolio's asset allocation determines the portfolio's risk and return characteristics. To maintain its original risk and return characteristics over time, the portfolio must be rebalanced. This paper identifies the factors that influence a rebalancing strategy. We present a conceptual framework for developing rebalancing strategies that can accommodate changes in the financial market environment and in asset class characteristics, as well as account for an institution's unique risk tolerance and time horizon. We conduct simulations to analyze how these different factors and different rebalancing guidelines affect a portfolio's risk and return characteristics. We conclude with a review of practical rebalancing considerations.