Aligning Risk Tolerance With The Rebalance Interval And Portfolio Composition

  1. Exploring Rebalancing Intervals

 

The Rebalancing Interval is the foundational variable that dictates the amount of risk present within an investment process.

In the case of an automated strategy, the system is unaware of any development outside of those dates when rebalancing is scheduled. Think of it as an “information blind spot”.

Logic dictates that shorter rebalancing intervals (daily, weekly) are suitable for low-risk strategies, whereas longer intervals (2 weeks and up) take on more risk due to the duration of the “blind spot”. However, in practice, this is not always the case. Backtesting is required to analyze the balance.

Aligning your Risk Tolerance with the Rebalancing Interval is critical. The Financial Industry thrives on activity, trading and swapping one instrument or strategy in favor of another. Activity generates fees, while remaining passive does not. As investors, our job is to remain disciplined and “stick to the plan” - especially as it pertains to the core function of Portfolio Rebalancing (which is what generates trades).

Rebalancing Interval Impact: The frequency of rebalancing affects both risk and returns:

  • Daily Rebalancing: Example strategy showed 28% returns with an -11.8% max drawdown (lower risk but lower returns).

Weekly Rebalancing: Same strategy yielded 39% returns with a -13% max drawdown (higher risk, better returns). Note the increase in Sharpe Ratio to 0.759.

Monthly Rebalancing: Achieved 40% returns with a -12.1% max drawdown (best risk-reward balance).

While the performance pales in comparison to buying and holding SPY (the Benchmark in the screenshots), the strategy is completely viable from a risk-reward perspective. Attaining +7.1% annualized returns with a -12.1% maximum drawdown represents a ratio better than 1:2 which is considered the gold standard in risk-reward between these two variables.

KEY ACTION STEPS: Explore the effect of the rebalancing interval within a certain investment process using the Quick Launch feature.

  1. Add the Millennium Alpha Stock Screener to your profile by clicking the link: https://live.signal-sigma.com/invitation/stock-screener/-LtIqOZS

  2. Click Actions > Duplicate so that you own an editable copy of the screener;

  3. Limit the “Millennium Alpha Rank Number” filter to the bottom 15 stocks on your chosen tab;

  4. Click “Launch Backtest”;

  5. Test different rebalancing intervals on Page 2; the Quick Launch feature allows you to launch a backtest without leaving the backtesting form.

Equally important though less talked about: consider the realistic constraints of your chosen rebalancing schedule and how it fits into your daily routine. Our simulations do not take into account any brokerage fees.

Once you have a good feel for how the rebalancing interval impacts a chosen process, it’s time to focus on your specific risk tolerance and which instruments go into your strategy portfolio.