Rebalancing in Action
A disciplined process for rebalancing your investment portfolio is among the keys to long-term investment success. Rebalancing is designed to keep your portfolio's targeted allocation across various asset classes, and intended level of risk, consistent over time. If you never rebalance your portfolio, you're letting the market dictate its level of risk rather than being intentional about it.
Rebalancing helps to reduce risk over the long-term
The result of disciplined rebalancing over the long-term is that it tends to reduce risk. Rebalancing can also potentially enhance long-term returns, although that is very time period dependent. Risk is reduced because over the long-term, riskier asset classes such as stocks tend to go up in value and become more and more of a portfolio. That increasingly raises the portfolio's level of risk, with more downside potential when markets become volatile. Periodically rebalancing back to the targeted allocation helps avoid letting the portfolio drift to a higher (or lower) risk allocation than intended.
How asset class volatility affects portfolio rebalancing
So if an investment in your portfolio sees a sharp decline or rally, should you expect to see rebalancing trades? Possibly, but not necessarily. When considering rebalancing, it's important to recognize that the weighting of each asset class in your portfolio is determined not just by the price movement of that asset class, but also by the price movement of every other asset class. In other words, a 10% decline or advance in stocks isn't enough information to know whether that move would trigger a rebalancing. We also would need to know how much price movement occurred in every other investment.
Asset allocation is a balancing act. In the financial world—as in the physical one—nothing happens in a vacuum. Money that flows out of one area of the market must flow into another, which means there are a lot of moving parts to consider at any given time. To help illustrate how asset class price movement leads to changes in weightings and potential rebalancing, let's take a look at a simplified example.
A rebalancing case study
For this case study, we've put together a simple hypothetical portfolio (with an initial value of $50,000) consisting of four asset classes. Note that this does not represent any actual allocation made through Schwab Intelligent Portfolios®, where each portfolio is broadly diversified and can comprise up to 20 individual asset classes, including cash.
- U.S. stocks (30%)
- International stocks (20%)
- Emerging market stocks (10%)
- Bonds (40%)
Table 1 shows the initial hypothetical portfolio and the number of shares, price per share, dollar value and weighting of each asset class in the portfolio.
| Number of shares | Price per share | Value | Weight | |
|---|---|---|---|---|
| U.S. stocks | 300 | $50 | $15,000 | 30% |
| International Stocks | 500 | $20 | $10,000 | 20% |
| Emerging market stocks | 200 | $25 | $5,000 | 10% |
| Bonds | 400 | $50 | $20,000 | 40% |
| Total portfolio value | - | - | $50,000 | 100% |
In Table 2, we consider how potential price movement in each of the four asset classes would change the weightings of each allocation and potentially result in a portfolio rebalancing.
| Number of shares | Price move | New price per share | New value | New weight | Change in weight | |
|---|---|---|---|---|---|---|
| U.S. stocks | 300 | -5% | $47.50 | $14,250 | 28.9% | -1.1% |
| International stocks | 500 | -10% | $18 | $9,000 | 18.3% | -1.7% |
| Emerging market stocks | 200 | -20% | $20 | $4,000 | 8.1% | -1.9% |
| Bonds | 400 | 10% | $55 | $22,000 | 44.7% | +4.7% |
| Total portfolio value | - | - | - | $49,250 | 100% |
As illustrated in Table 2, emerging market stocks had the biggest price move (-20%) but didn't drift as far from their targeted weighting as bonds, which had a smaller move (+10%). In this case, the change in weighting for bonds could trigger a rebalance in which bonds would be sold to bring the asset class back to its targeted weighting of 40%.
Although other asset classes saw smaller weighting changes and might not have triggered a rebalance themselves, the proceeds from the sale of the bonds should be reinvested. This would be accomplished by iteratively buying shares of underweight asset classes, beginning with the most underweight. In this example, emerging markets is the most underweight, so proceeds would first be used to buy enough shares to bring this asset class back as close as possible to its target weight. If proceeds remained after buying these shares, the algorithm would next buy international stocks because that is the next most-underweight asset class.
Conclusion
Schwab Intelligent Portfolios uses the power of technology along with human oversight to automatically monitor your portfolio on a daily basis and rebalance as needed. In our simplified example, one asset class triggered a rebalance, but other asset classes also experienced rebalancing trades. Importantly, while portfolios are monitored daily, rebalancing occurs only as needed when an asset class drifts far enough from its intended weighting in the portfolio to warrant a rebalancing trade. That typically results in a couple of rebalancing events per year in an average market environment. In a more volatile environment, the number of rebalancing events might be a bit higher, and in a very calm market environment it might be lower.
The objective of Schwab Intelligent Portfolios is to recommend a suitable allocation based on your goals and risk profile and keep that allocation consistent through rebalancing. It is not a strategy that uses tactical adjustments based on short-term market views to try to "beat the market" through market timing. The number of rebalancing trades will vary depending on the market environment, but the process is designed to keep your portfolio's risk profile consistent, while not overtrading based on slight deviations from targeted weights for each asset class.
The broad diversification within Schwab Intelligent Portfolios—spanning about 20 asset classes in any portfolio—means that implementing this rebalancing process could be complex and challenging for an individual investor trying to manually manage his or her portfolio. This is one of the areas where the power of technology shines, by allowing us to simplify the portfolio management process and make important features like rebalancing more efficient.