Rebalancing Investments - Rebalancing To Control Risk

Rebalancing To Control Risk

The investments in a portfolio will perform according to the market. As time goes on, a portfolio's current asset allocation will drift away from an investor's original target asset allocation (i.e., their preferred level of risk exposure). If left unadjusted, the portfolio will either become too risky, or too conservative. If it becomes too risky, that will tend to increase long-term returns, which is desirable. But when the excessive risks show up in the short term, the investor might have a tendency to do the worst possible thing at the worst possible time (i.e., sell at the bottom), thus dramatically diminishing their ending wealth. If the portfolio is allowed to drift to a too conservative status, then excessive short-term risk is less likely, which is desirable. However, long-term returns would also tend to be lower than desired, which is less desirable. So it is best to maintain a portfolio's risk profile reasonably close to an investor's level of risk tolerance.

The goal of rebalancing is to move the current asset allocation back in line to the originally planned asset allocation (i.e., their preferred level of risk exposure). This rebalancing strategy is specifically known as a Constant-Mix Strategy and is one of the four main dynamic strategies for asset allocation. The other three strategies are 1) Buy-and-Hold, 2) Constant-Proportion and 3) Option-Based Portfolio Insurance.