Rebalancing is the process of realigning the weightings of a portfolio of assets to maintain the original or desired level of asset allocation and risk.
Understanding portfolio rebalancing
When Elephants build an investment strategy, a portfolio usually begins with a target asset allocation based on a specific risk tolerance and investment time horizon. As global markets fluctuate, the values of individual assets change at different rates. This market drift causes the portfolio to deviate from its original target weights, which alters the overall risk profile of the investments.
To rebalance, an investor sells a portion of the assets that have increased in value and uses those funds to purchase assets that have declined or grown at a slower pace. This mathematical adjustment returns the portfolio to its intended design. Investors typically rebalance on a scheduled basis, such as quarterly or annually, or when an asset class deviates from its target weight by a predetermined percentage.
The method and frequency of rebalancing depend on individual strategy and regional tax regulations. Because rebalancing often requires selling profitable assets, it can trigger capital gains taxes. Tax rules vary heavily by jurisdiction, so international investors often choose to direct new capital contributions or dividend payouts into underweighted asset classes to rebalance the portfolio without selling existing holdings and incurring immediate tax liabilities.
Example
Suppose an Elephant decides to build a retirement portfolio with a target allocation of 60% global equities and 40% government bonds. The initial investment is 100,000 euros, split into 60,000 euros for equities and 40,000 euros for bonds. Over the next year, a strong market causes the equity portion to grow to 80,000 euros, while the bond portion remains at 40,000 euros. The total portfolio value is now 120,000 euros. Equities now represent 66.6% of the portfolio, and bonds represent 33.3%.
To return to the target 60/40 allocation, the Elephant must rebalance the portfolio. The new target value for equities is 72,000 euros, which is 60% of 120,000, and the new target value for bonds is 48,000 euros, which is 40% of 120,000. The Elephant sells 8,000 euros of the equity holdings and uses the proceeds to buy 8,000 euros of government bonds. The portfolio is now rebalanced to its original risk profile.