Market movements can offer a chance to buy certain securities when they are underweighted and sell when they’re overweight. It all comes down to this: buy something cheap, keep it, and sell it when the price goes up, making a profit that can be used on purchasing something else that has a low price at that moment. To guarantee success in this trade, the whole journey has to begin with a diversified portfolio of investment vehicles. a diversified portfolio is the goal of the whole rebalancing practice.
What’s more, securities need to have dissimilar price movements (different categories of equities) so the investor doesn’t have all their eggs in one basket. In other words, category 1 might be declining while category 2 is going up and category 3 remains stable; this condition A plus condition B rebalancing is necessary to maintain risk tolerance and earn money.
Portfolio construction and rebalancing basics
Before we go any further, let’s look at some fundamental terms and methods to estimate the figures therein:
Compound annual growth rate (CAGR), or annualized return
: The amount of money made by an investment over a period of time if the annual return is compounded. This is a geometric average that is calculated as:
where
r1, r2 … rn is the respective annual returns for year 1, year 2 … year n
and n is the number of years an investment has been kept in, e.g., a mutual fund.
Let’s say we have a security that has the following five-year annual returns: