Optimal Rebalancing Strategy for a Two-Asset Stock and Bond Portfolio
AuthorLing-Barnes, Sheau Y.
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It is commonly believed that a continuously rebalanced investment portfolio achieves the optimal investment returns by maintaining a diversified portfolio that satisfies each individual investor's risk aversion or tolerance level. However, frequent rebalancing is costly. This paper sought to determine the optimal rebalancing method of a 60/40 stock and bond portfolio, taking into consideration transaction costs and capital gains taxes. This rebalancing method looked into two strategies of approach: time interval and percentage movement rebalancing. The first strategy rebalances a portfolio by a set frequency, be it monthly, quarterly, or yearly, etc. The second strategy rebalances a portfolio by a certain percentage movement away from the portfolio's original 60/40 mix. The findings from this exercise indicated that less frequent rebalancing is ideal for achievable maximum investment returns, including or excluding transaction costs and taxes. This finding is also consistent with the fact that rebalancing by higher percentage movement also achieves the same results of higher portfolio returns. However, with either strategy mentioned above, the longer the interval or the bigger the percentage movements away from a portfolio's original mix, the higher the standard deviation because in either case, the stocks eventually dominate the portfolio and causing it to deviate significantly from its original mix of 60/40.