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Rebalancing Test

The need to rebalance a portfolio effectively is one of the critical responsibilities of sophisticated asset management.  All investment strategies need to be rebalanced periodically, as the portfolios drift from their original allocations.  The question is: what criterion should be used to decide when to rebalance?

Unfortunately, a rigorous basis for defining portfolio rebalancing has been an open question for over 50 years.  Portfolio rebalancing has been based largely on ad hoc criteria with little theoretical or empirical justification.  Rebalancing rules in practice are frequently calendar based; e.g., monthly, quarterly, or annually.   Alternatively, managers employ range rules and rebalance the portfolio when an asset drifts outside of a prescribed range relative to optimality.  Such rules are often ineffective. 

Rebalancing requires a measure of statistical significance to determine whether the optimal portfolio is different from the current portfolio in terms of likely performance in the investment period. 

Michaud optimization provides the statistical tool for creating a rigorous procedure for portfolio rebalancing.  Our patented rebalancing test determines whether or not a significant difference exists between the selected portfolio on the efficient frontier and the current holdings relative to likely performance.  This need-to-trade test prevents ineffective and costly trades while enhancing investment value.

rebalancing probability curve

Updated Research

Efficient Asset Management (2nd edition) offers the most complete description of Michaud rebalancing. "Resampled Portfolio Rebalancing and Monitoring" provides an intermediary step between the original rebalancing procedure and what it is today.

C. Michael Carty's 2001 article "A High-Wire Act for Advisors" (Financial Advisor) describes the problem of rebalancing from the advisor's perspective.

Patented Research