A Finance question: Can you please explain and break down the following paragraph.

Question

Finally, the remaining chapter discusses the significance of portfolio rebalancing in maintaining optimal asset allocation. Rebalancing involves realigning portfolio weights periodically to restore the desired allocation. Various rebalancing approaches, including time-based and threshold-based methods, offer flexibility in managing portfolios. Investors must be cautious of common rebalancing mistakes such as mechanical adherence to schedules and overlooking transaction costs and tax implications. Rebalancing strategies aim to mitigate drift and control risk exposure amidst market fluctuations. Effective rebalancing protects against asset bubbles and ensures a specified risk level over time. Investors need a strategic approach to rebalancing, considering factors like personal preferences, transaction costs, and tax considerations. These pages underscore the importance of disciplined rebalancing to maintain portfolio alignment and achieve long-term investment objectives.

Answer 1

First of all, it is important to note that the optimal asset allocation depends on the investor's return objective and risk profile. The higher the expected return an investor has, the larger the amount of risk he or she should be willing to accept. Once the investor's return and risk objectives are aligned, you can start constructing the optimal asset allocation (stock, bonds, alternatives, and others) that aim to achieve those objectives. Over time, as asset prices move, portfolios have to be rebalanced to the strategic asset allocation established at the beginning with the investor. A number of factors have to be taken into consideration before executing a rebalancing, including volatility of the various asset classes and transaction costs. The idea is not to rebalance too quickly and create excessive transaction costs for the investor or too slowly that the portfolio deviates too much from the strategic (original) asset allocation. The objective of rebalancing should be that over time the strategic asset allocation remains within the boundaries established so that it generates the expected return and risk that the investor desires.

Answer 2

Okay, I'm going to try and explain this simply: So in portfolio management, managers have portfolios consisting of various asset classes or portfolios of individual assets (stocks, bonds, commodities, etc.). Now, there is this notion of the Capital Asset Pricing Model (CAPM) that is important (but also wrong!). It is a part of the efficient frontier, which is essentially a rectangular hyperbola of different points within the risk/return spectrum (see: https://upload.wikimedia.org/wikipedia/commons/e/e1/Markowitz_frontier.jpg).

Now, managers want their portfolios to be on the line (ideally at the tangency or minimum variance portfolio depending on goals) to maximize return and/or minimize risk. To find these points, weights are assigned to each asset and quant researchers apply a formula with regression (and other tools) to identify the right combination of weights that achieve one of these points.

However, just as the economy changes, so do these weights, and so the portfolio needs to be rebalanced to achieve their goals. Time-based and threshold-based are two ways of doing so; time-based involves rebalancing periodically (eg. every quarter) whereas threshold-based looks at the allocation for assets and changes them when they go beyond a given threshold (eg. when fixed income crosses 20% of the portfolio).

But, of course, there are issues with each strategy and so like the text mentions, those decisions have to be made judiciously. To give some examples, some momentum strategies may encounter crash risk and transaction costs, while currency carry, on the other hand, can face liquidity or volatility risk.

Long story short, rebalancing a portfolio is important to ensure that an investor's (long-term) goals are met, and it is important to look at all the risk factors that may arise when going about a rebalance.

If you're interested, I recommend checking out the work of Markowitz, Fama/French, Ilmanen, and pretty much most research that AQR puts out to learn more. Hope this helps!