What is the primary purpose of portfolio rebalancing?

The primary purpose of portfolio rebalancing is to adjust the weights of assets in a portfolio to maintain the intended level of risk and return. Over time, as different investments in a portfolio grow at different rates, the original asset allocation can drift away from the intended strategy. For example, if equities outperform fixed income assets, the percentage of equities in the portfolio may increase significantly, raising the overall risk beyond the investor's comfort level or risk tolerance.

Rebalancing involves selling some of the asset classes that have increased in value and buying those that have decreased in value relative to the portfolio’s strategic asset allocation. This process helps to ensure that the portfolio continues to align with the investor’s long-term financial goals and risk profile, thereby maintaining the desired balance between risk and return.

It is important to note that focusing solely on increasing the total value of the portfolio, selling off underperforming assets only, or investing in new asset classes may not address the underlying issue of maintaining an appropriate risk-return profile. These approaches can overlook the fundamental strategy of rebalancing, which is about adhering to a predetermined asset allocation that reflects the investor's objectives and risk tolerance.