The investment policy
- Define your objectivesWhat you want to achieve (capital growth, regular income, capital preservation) and by when.
- Assess your constraintsLiquidity needs, horizon, tax considerations, knowledge and experience, personal preferences.
- Set the target allocationWeights by asset class, consistent with your risk profile — for example, 60% equities and 40% bonds.
- Set limits and rulesTolerance bands, maximum weights per issuer, review frequency and rebalancing method.
- Implement and monitorSelect the instruments, track results against your objectives and revise the policy only when your circumstances genuinely change.
Why and how to rebalance
Different returns across asset classes shift the portfolio's weights over time. After a period of rising equity prices, the portfolio becomes riskier than originally intended. Rebalancing brings the weights back to target and maintains the chosen risk profile; its main purpose is not to maximize returns.
| Criterion | Periodic rebalancing | Threshold rebalancing |
|---|---|---|
| Trigger | At fixed intervals (for example, annually) | When a weight moves outside its tolerance band (for example, ±5 percentage points) |
| Advantages | Simple, predictable, easy to follow | Trades only when the deviation is significant |
| Disadvantages | Can generate unnecessary trades or miss large deviations between dates | Requires continuous monitoring |
| Costs | May be incurred at every date, regardless of the deviation | Generally fewer trades |
A numerical rebalancing example
The rule you choose matters: with annual rebalancing, the trade above is executed. With a tolerance band of ±5 percentage points (55%–65%), the 64.10% weight is still inside the band, so nothing is traded. An alternative that avoids selling is to direct new contributions: if the investor adds MDL 50,000 to bonds only, bonds reach MDL 470,000, the total reaches MDL 1,220,000 and the equity weight falls to 750,000 ÷ 1,220,000 ≈ 61.48%.
Discipline and behavioral mistakes
By its nature, rebalancing requires you to sell what has gone up and buy what has gone down — exactly the opposite of your emotional impulse. That is why a rule set in advance is more valuable than a decision made under market pressure.
- Loss aversion: losses are felt more strongly than equivalent gains, which leads to panic selling.
- The disposition effect: the tendency to sell winning securities too early and hold on to losing ones for too long.
- Overconfidence: overestimating your own ability to predict the market, leading to excessive trading.
- Herd behavior: following the decisions of the majority instead of your own analysis.
- Anchoring: basing decisions on an irrelevant reference price, such as the purchase price.
Key takeaways
- A written investment policy sets out objectives, the target allocation, limits and rules before you invest.
- Rebalancing brings the portfolio back to the chosen risk profile; its main purpose is risk control.
- Periodic rebalancing is simple, while threshold rebalancing trades only when deviations are significant.
- Trading costs and taxes influence the optimal rebalancing frequency.
- Rules set in advance help you avoid behavioral mistakes.
Check your knowledge
Answer all the questions. If you answer all of them correctly, the lesson is marked as completed automatically.
Explanation: Target = 0.60 × 1,170,000 = MDL 702,000; amount to sell: 750,000 − 702,000 = MDL 48,000.
Explanation: The threshold rule triggers rebalancing only when the weight moves outside the band; 64.10% is below the 65% limit.
Explanation: Rebalancing brings the weights back to the target allocation, preserving the chosen level of risk; it is not a tool for predicting the market.
Educational material only. It does not constitute investment, legal or tax advice. Numerical examples are hypothetical.