Automatic rebalancing is a relatively new technique in the financial industry to help keep risk in check. The value of investments is constantly in a state of flux. And over time, the balance between stocks, bonds, and other asset classes within a portfolio can shift drastically.

Investment strategies often define a strict set of ratios between asset classes. These ratios are commonly referred to as target asset allocation.

A more aggressive growth portfolio will likely have a higher proportion of stocks to bonds, while a conservative portfolio would be the opposite. Professionally-managed investment portfolios are rebalanced regularly. And as the name suggests, automatic rebalancing automates this process.

What is automatic portfolio rebalancing?

Automatic rebalancing is offered by many trading platforms and brokerage accounts today. Using algorithmically-based software, the allocation of different asset classes within a portfolio can be automatically realigned at a specified interval – typically once per year. This can be pretty convenient for individuals with limited time or investing knowledge and further helps put investments on autopilot.

Traditionally, portfolio rebalancing is done manually based on recommendations offered by a financial adviser. But hiring a professional to manage an investment portfolio can be quite expensive. Robo-advisers, on the other hand, are a far cheaper alternative and offer automated portfolio rebalancing solutions, usually by default.

But why is rebalancing important in the first place?

It all comes down to risk. A conservative investor close to retirement may have a portfolio comprising 30% stocks and 70% bonds. But after a stock market rally, the value of their shares increased drastically. That’s obviously good news, but it’s also shifted the balance between bonds and stocks.

Shares now represent 40% of the overall portfolio, resulting in a higher risk profile beyond the limits of the original investment strategy.

To rebalance the asset mix and bring risk levels back down, the investor can either invest new capital into bonds or take profits from their equity returns and invest the proceeds into bonds. The objective is to return the balance back down to the original asset allocation or to a renewed target allocation.

Through automatic rebalancing, this entire process is handled by a computer, allowing the investor to focus on other things.

How does this strategy work?

When it comes to rebalancing an investment portfolio, there are four primary methods available to investors:

• Manual Rebalancing – An investment manager is hired to keep track of the ratio between asset classes in an investment portfolio. They design a rebalancing strategy and advise on which positions to divest or bolster in exchange for a fee that typically lies around 1% of an investor’s portfolio value per year.
• DIY Rebalancing – An individual Investor can decide to rebalance without an investment adviser’s help and rely on their own research and judgement to make decisions. While this avoids paying any fees to a professional, it requires skill and emotional discipline that many investors don’t possess. A badly rebalanced portfolio can significantly underperform over the long term. Therefore DIY investing is typically not recommended for novice investors with next-to-no experience.
• Rebalancing Investments – Instead of picking individual stocks and bonds, investors can invest in a mutual fund or exchange-traded fund, where the fund manager makes all the rebalancing decisions on their behalf. For example, target-date funds constantly rebalance to account for an investor’s age.
• Automatic Rebalancing – The rebalancing decisions are executed based on a trading algorithm. Automatic rebalancing is usually an optional premium service that charges a small fee proportionate to the size of an investor portfolio. Typically the charges for this service sit around 0.5% of an investor’s portfolio value per year, making it a cheaper alternative to hiring an investment manager.

What are the advantages of automatic rebalancing?

While automatic rebalancing may not be suitable for everyone, it does offer some noteworthy advantages.

• Removes Emotion – Emotions are removed from the equation by keeping the process automatic. This prevents the risk of falling into an emotional investing trap and better protects wealth.
• Maintains Diversification – As an asset class grows and shrinks within an investment portfolio, diversification can be adversely affected. Through automatic rebalancing, this no longer poses an issue.
• Stays The Course – Rebalancing asset allocation ensures an investment strategy remains on track, delivering on the investment goals, time horizon, and risk tolerance of an investor.
• No Knowledge Requirements – Investors don’t need to know how to rebalance their portfolios manually, as a trading algorithm makes all the decisions on their behalf.
• Investing Autopilot – Investors don’t need to think about rebalancing, as the process is completed automatically.
• Low Fees – Automatic rebalancing is typically cheaper than hiring an investment adviser to rebalance a portfolio manually.

What are the disadvantages of automatic rebalancing?

As advantageous and cost-effective as automatic rebalancing may be, there are some significant drawbacks for investors to consider.

• No Human Input – All investment decisions are made by a computer, typically with next-to-no human intervention. For investors trying to understand why certain decisions are being made, it may be impossible to get an answer without paying for professional help.
• No Control – Beyond some general outlines, investors typically have no say in where their capital is reallocated.
• Contradicts Buy & Hold Investing – Buy & hold investors don’t typically use aggressive rebalancing techniques as they operate with longer time horizons. Using automatic rebalancing may result in a position being sold against the investor’s will.
• Clips Winning Investments – A stock that has surged to new heights is likely to be targeted by an automatic rebalancing algorithm as the position becomes a larger chunk of the overall portfolio. However, it’s possible that the shares may be set to surge even higher in the long term. And by selling shares today, the investor misses out on all the additional future growth.
• More Transaction Costs – Unlike manual rebalancing, automatic rebalancing is a constant process that will activate as soon as a portfolio deviates from the specified target asset allocation. During a period of heightened market volatility, this can trigger a significantly higher level of transactions resulting in higher commission and trading costs.

The bottom line

The financial markets are constantly moving up and down. And this volatility can often cause a portfolio to veer off track. Automatic rebalancing helps correct this potential portfolio problem, reducing risk exposure with minimal effort required by the investor.

However, rebalancing a portfolio too frequently can quickly rack up additional costs while undermining its long-term performance. Investors need to weigh the pros and cons before using this type of service or platform feature.

This article contains general educational information only. It does not take into account the personal financial situation of the reader. Tax treatment is dependent on individual circumstances that may change in the future, and this article does not constitute any form of tax advice. Before committing to any investment decision, an investor must consider their individual financial circumstances and reach out to an independent financial advisor if necessary.