Don’t underestimate the effect of risk on your portfolio. To see what can happen along the way, assume that you invest RM10, 000 at an expected annual return of 10% for the next five years. It turns out that you do not only fail to see any returns in your first year, you also lose 30% of your capital. To recover the amount you would have accumulated after five years had your expected return of 10% been achieved, you would have to earn an annualized return of 23% over the remaining four years. If this had happened to you in the second year, it would mean that you would need an annualized return of 23% to recapture your original position.
Volatility plus the effect of compounding long-term annualized returns make it hard to get a fix on how much money you’ll have (on not have) in the future and the opportunity costs can, as illustrated, be disastrous. How do you tame risk? The likelihood of “losing” is reduced when we can find a portfolio with low volatility. Low vitality is in turn achieved by locating low-correlation assets. Such as portfolio is diversified (or better, optimized) and has a risk-return profile that captures a target return to achieve long-term goals while taking into consideration one’s appetite for risk.
Rebalancing where and when appropriate keeps the portfolio true to the original risk-return profile. In theory, rebalancing can be done in several ways. It can involve the realignment of portfolio weightings between asset classes, within asset classes, between sectors or between securities themselves. Essentially, any form of rebalancing is a bet that securities’ prices will regress to the mean – in other words, that last period’s top performers won’t come out on top again this period and that today’s losers will become tomorrow’s winners. The mean in this case would be your target rate of return.
By unloading an asset class that has enjoyed a nice rise, you manage to sell high, although not necessarily at the highest high, because you aren’t trying to time the market. In the process, you escape the inevitable decline of that asset class. Similarly, if you assume that segments beaten down by market forces will one day rise again, buying more of these securities will ensure that you end up owning sufficient amounts to boost your total portfolio return when that asset class ultimately recovers.
Rebalancing , in short, is not only a discipline for buying low and selling high but also a way of remaining true to the asset allocation you have established, thus ensuring the full benefit of diversification according to particular tolerances for risk.
So how do the professionals do it? One of the most common approaches to rebalancing is periodic rebalancing. Studies have shown that calendar-year rebalancing is optimal when done no more than once a year and no less than every four years.
If assets move sideways for an extended period, you wouldn’t need to rebalance just because a specified time had elapsed. Alternatively, if stocks rose 1% per day, you won’t want to wait for more than a year to rebalance. Such a scenario would call for a “threshold” rebalancing approach. This strategy calls for a portfolio to be rebalanced when asset weightings depart from their original allocations by more than a stated amount; in other words, when the weightings cross a certain threshold.
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