Rebalancing is the process of buying and selling investments in a portfolio to adjust their weightings back to the target allocation of the portfolio. Done systematically, it is intended to keep portfolios ‘on target’ for their allocations, and become a systematic process of “buying low and selling high” to enhance returns.
When rebalancing amongst similar-returning asset classes, there does appear to be a “rebalancing bonus” available, as long as those investments ultimately revert back towards their long-term expected returns after short-term deviations. The greater the volatility of the investments, and lower the correlations between them, the greater the rebalancing bonus can be.
The timing of rebalancing is a significant factor in its benefit. Rebalancing too often can further damage returns by selling down favorable investments too early, and buying into declining ones while they are still heading lower. However, rebalancing too rarely forfeits return-enhancing opportunities altogether.
Rebalancing can and likely will trigger a modest amount of capital gains, since the process by its nature will sell investments that are up (the most, with the most in capital gains). However, relative to the overall size of the portfolio, rebalancing-driven turnover is often still fairly modest, and can be partially ameliorated by both strategic asset location decisions, and simple strategies like capital loss harvesting (to offset any rebalancing gains).
For some clients, rebalancing may be difficult to execute, because it requires selling what is up and buying what is down (while many clients are behaviorally tempted to do the opposite. On the other hand, committing to a rebalancing strategy in advance can actually help clients to avoid this harmful psychological challenge.
The conventional view of rebalancing is that it is one of the “free lunch” opportunities in investing – a systematic strategy that enhances long-term returns, and a widely accepted best practice.