Threshold-Based Rebalancing Examples

Understanding Threshold-Based Rebalancing

Threshold-based rebalancing is an investment strategy used to maintain an asset allocation by adjusting holdings when they deviate from predetermined thresholds. This technique helps investors manage risk while capitalizing on market fluctuations. Below are three practical examples that illustrate how threshold-based rebalancing can be effectively implemented.

Example 1: Maintaining a Balanced Portfolio

In this scenario, an investor has a target allocation of 60% stocks and 40% bonds. They decide to implement a threshold of 5% for rebalancing, meaning they will take action if their asset allocation deviates by more than 5% from their target.

After a strong market performance, the investor’s portfolio shifts to 65% stocks and 35% bonds. Since the stock allocation exceeds the 5% threshold, the investor sells a portion of their stock holdings and uses the proceeds to buy more bonds, bringing the allocation back to the target of 60% stocks and 40% bonds. This approach helps the investor mitigate risks associated with overexposure to stocks during market highs.

Notes

• The threshold can be adjusted based on market conditions or individual risk tolerance.
• This example demonstrates how threshold-based rebalancing can protect against market volatility.

Example 2: Retirement Portfolio Adjustments

Consider a retiree who has a diversified portfolio consisting of 50% equities, 30% fixed income, and 20% cash. They establish a rebalancing threshold of 10%. After a market downturn, the portfolio’s allocation shifts to 45% equities, 35% fixed income, and 20% cash.

Although the equities have not reached the 10% threshold for rebalancing, the retiree reviews their portfolio and notices that the fixed income allocation has exceeded the threshold. Thus, they decide to sell some fixed income securities to invest back into equities, adjusting the allocation back towards their target of 50% equities. This decision helps the retiree capitalize on lower equity prices while maintaining a balanced risk profile.

Notes

• Retirees may prefer to use wider thresholds to avoid frequent trading costs.
• This example underscores how rebalancing can be especially important for maintaining income-generating investments in retirement.

Example 3: Young Investor’s Growth Strategy

A young investor has set a target allocation of 80% stocks and 20% bonds, with a rebalancing threshold of 7%. After a bull market, the investor’s allocation changes to 88% stocks and 12% bonds, surpassing the 7% threshold.

To rebalance, the investor sells enough stocks to bring the allocation back down to 80%. This action not only re-aligns their risk exposure but also allows the investor to take advantage of higher bond yields. By regularly rebalancing, the young investor can maintain their aggressive growth strategy while managing risk effectively.

Notes

• Young investors might opt for narrower thresholds to capitalize on growth opportunities.
• This example illustrates the importance of rebalancing in maintaining a long-term investment strategy without overexposing oneself to market volatility.