Chapter 21
Optimal Rebalancing
Intuition is nothing but the outcome of earlier intellectual experience.
—Albert Einstein
Fluctuations in the prices of risky assets affect overall portfolio value as well as the relative allocation of assets within the portfolio. Periodic rebalancing policies are therefore designed to preserve targeted allocations of risky and safe assets relative to their respective weights in a benchmark portfolio. Targeted allocations (for example, a 60/30/10 mix of stocks, bonds, and cash) are ultimately a statement of the portfolio's exposure to risk and, therefore, weight adjustments are necessary to prevent drift in risk due to underlying price volatility. Rebalancing also serves to minimize movements in the durations of portfolios of fixed income securities due to yield volatility, indicating that even portfolios of safe assets (for example, Treasury issues) are not immune to risk.
The objective is to rebalance to add value but minimize the risk of not meeting liabilities. Clearly, a do-nothing, buy-and-hold strategy will not control for risk. Calendar rebalancing may add value and minimize risk at the time rebalancing occurs, but the temporal nature of this rule-based policy means it cannot serve to optimally control risk and add value over time because of its arbitrary timing. Dynamic policies (constant mix and various forms of portfolio insurance) provide upside or downside protection, depending on the time series properties of asset prices (for example, ...
