Introduction

An old adage states that “where you stand depends on where you sit.” In the context of asset allocation, this translates into: sound investment advice must be based on the investor's unique situation. Some investors accept great risk for hopefully greater rewards. Others attempt to immunize their portfolios for fear of loss, however slight. Most investors fit somewhere between these two extremes.

A related issue involves the costs for making changes to an existing portfolio. Several asset categories require a substantial payment for either entry or exit, for example, real-estate or venture capital. Other investment categories generate small commissions, but trade in a relatively thin market. Therefore, institutions and other large investors may pay substantial market impact costs whenever a change is made in the makeup of their portfolios. Smaller capitalized US stocks display this feature — estimates range from 80 to over 400 basic points for each side of these transactions.

Despite the importance of turnover and transactions costs, most asset allocation programs treat the rebalancing issue in a simplistic fashion. Recommendations do not depend upon the investor's current portfolio; for example, “average” transaction costs are subtracted from expected returns. The rebalancing costs are often ignored.

This chapter develops a systematic approach for rebalancing a portfolio.