13 Rebalancing: Tracking a target portfolio
This chapter covers
- Rebalancing portfolios with defined target weights, and the pitfalls of not rebalancing
- Simple rebalancing rules based on fixed time schedules or deviation thresholds
- Optimization-based rebalancing incorporating transaction costs and taxes
Over time, a portfolio may naturally drift away from its target weights due to differing changes in asset prices. Rebalancing refers to the process of periodically correcting the drift to bring the portfolio closer to its target weights. In this chapter, we’ll show why rebalancing is important and cover various methods for rebalancing, starting with the simplest and ending with the most sophisticated.
13.1 Rebalancing basics
Earlier chapters have discussed ways of constructing portfolios that are “optimal” in some sense. They optimized an objective function—for example, maximum expected return or minimum tracking error—with some constraints on the portfolio weights.