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What is portfolio rebalancing and why investors should care
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STRATxAI

February 2024 · 5 min read

What is portfolio rebalancing

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Intermediate

Whether you are focussed purely on quantitative strategies or have diversified in other asset classes, once you have set up your investment portfolio you will have some ongoing maintenance to keep it in line with the metric in your risk budget.

Rebalancing a portfolio requires the buying and selling of positions in your portfolio to get back to your original asset allocation. When one asset class significantly outperforms another, your portfolio drifts from its starting allocation.

Read on as we explain the process of rebalancing various asset classes or click here to learn specifically how to rebalance an STRATxAI portfolio.

1: Rebalancing a stock and bond portfolio

A classic investor holding stocks and bonds, may have decided to hold 50% of their portfolio in stocks and 50% in bonds at all times. They could plan to rebalance the portfolio on a monthly basis.

In this scenario lets assume the stock market consistently increases while the bond market decreases each month. At the end of each month, the investor rebalances and sells 3% worth of his strongly performing stock portfolio and buys 3% of the underperforming bond portfolio. This ensures his overall portfolio allocation to stocks and bonds stays consistent at 50% and 50%.

Without rebalancing, their exposure/risk to the stock market would have significantly increased through the year until they ended up in December with a whopping 83% of their money in stocks.

2: Rebalancing in the quantitative investing world

The reason rebalancing is particularly crucial in a quantitative investing framework is that most of the strategies that users may invest in, were backtested with a specific rebalancing frequency.

A quantitative strategy by design will have a rebalance period that was used in the construction of the strategy.

A quantitative strategy uses data, either price+volume or fundamental balance sheet data, to decide at any point in time which companies are the best to invest in. This data changes with time, so this means the quantitative strategy needs to account for this and update the “buy recommendations”. Updating the buy recommendations is equivalent to a rebalance frequency as the strategy will give a new list of stocks to invest in at that rebalance date, using this new price or fundamental data.

So if stocks that are currently in your portfolio are not listed in the updated quantitative strategy list, then they need to be sold and the new ones from the list added to your portfolio. This is the rebalance.

Deciding your rebalance period

When selecting a quantitative strategy an investor is relying on a set of backtested results in order to reap returns in the future. We highlighted in the previous section, how quantitative strategies and backtests need to use updated information and that dictates the need to rebalance. Otherwise, if there is no rebalancing frequency the strategy is just a buy-and-hold strategy where the stocks you own on day one are still in your portfolio years later.

For any investor, the rebalance period they use for their portfolio is their own decision and it should consider a few elements:

  • Execution Costs. The more frequently a user rebalances, the more transaction costs they incur, which can degrade performance and increases the chance of slippage (slippage means your executed price differs from what you expected)
  • Practicalities. Does the investor have the time and resources to commit to execute the rebalance trades on time every rebalance period
  • Design of the strategy. Take into consideration the rebalance period used in the design of the quantitative strategy, but don’t feel bound to it. A strategy may be based on a fortnightly rebalance but you may still prefer to rebalance at month end.
3: Rebalancing an equity portfolio

Rebalancing an equity portfolio has more similarities to our example of (2) quantitative rebalancing than our example of (1) stock and bond portfolio rebalancing.

This is because users of the STRATxAI platform are most likely running a small number of equity portfolios only. These strategies were also built and backtested using a rebalance period as specified in the construction of the strategy.

Here is an example using a sample 5 stock portfolio.

At the end of January the strategy will indicate the list of 5 stocks that need to be in the portfolio for February. The investor will rebalance by selling their GOOG and AMZN positions and buying NFLX and META.

At the end of February the list will be reviewed for the coming month again. The rebalance will require the investor to sell their TSLA position and buy NVDA at the start of March.

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