Portfolio
rebalancing requires a trade-off between the cost of
rebalancing and the cost of not rebalancing. Costs of rebalancing include
trading costs and taxes, which must be weighed against:
- the
reduction in expected portfolio value resulting from suboptimal asset
allocation
- exposure
to greater risk as the riskier assets typically earn more and become a
larger percentage of the portfolio
- shifting
risk factors as asset weights change
- using
rebalancing to reduce exposure to the assets that have risen most and may
be overvalued
To reflect this trade-off, rebalancing is typically performed in a
disciplined fashion, based either on the calendar or on tolerance corridors.
Calendar rebalancing takes place at specific times, and as such
does not require constant monitoring. However, it is insensitive to market
conditions and may allow weights to drift substantially between rebalancings.
Tolerance corridors call for rebalancing whenever an asset class
drifts out of proportion to a pre-specified range around the target weight. It
allows tighter control as it is directly related to market performance, but
also requires continuous monitoring.