How To Balance Your Forex Portfolio Assets..

Managing a forex-heavy portfolio requires systematic rebalancing to ensure that asset weights remain aligned with your goals. Systematic rebalancing involves adjusting the weights of assets in a portfolio to maintain desired risk and return characteristics or mitigating over-exposure risks. This process can mitigate the impact of market volatility and currency fluctuations. Understanding the optimal frequency and thresholds for rebalancing is crucial for maximizing returns and minimizing risks.

1️⃣ Understanding Rebalancing

Rebalancing is the process of realigning the weightings of a portfolio of assets. This could mean adjusting the proportions of different currency pairs to maintain a specific risk profile.

Example: If a portfolio is composed of 50% EURUSD long and 50% USDJPY long and the EURUSD pair outperforms and hits some targets, you may be left with an overexposure of USD longs via the remaining EURUSD and the USDJPY longs. Rebalancing would involve either adding some USD shorts or washing some USD longs to restore balance.

2️⃣ Optimal Frequency of Rebalancing

The frequency of rebalancing can significantly impact portfolio performance. Rebalancing too often can incur high transaction costs and chasing, while rebalancing too infrequently can lead to drift from the target allocation. While quarterly or semi-annual rebalancing makes sense for investment goals, the optimal frequency for trading is quite more aggressive and requires a constant surveillance of the portfolio balance.

For forex-heavy portfolios, monitoring volatility and economic indicators can help determine the ideal rebalancing frequency. For instance, during periods of high volatility or central bank pivots, more frequent rebalancing might be necessary.

3️⃣ Setting Rebalancing Thresholds

Threshold-based rebalancing involves setting percentage limits that trigger rebalancing actions when asset weights deviate from their targets by a certain amount.

For example, if the target weight for EUR longs is 50%, a threshold of 5% might be set. If the weight of EUR longs exceeds 55% or falls below 45%, rebalancing would be triggered.

4️⃣ Calendar vs. Threshold Rebalancing

Calendar rebalancing involves adjusting the portfolio at regular intervals, such as monthly or quarterly, regardless of asset performance. Threshold rebalancing, on the other hand, only occurs when the weights of assets deviate beyond pre-set limits.

A portfolio might use calendar rebalancing every month or every quarter but also employ threshold rebalancing if any currency pair deviates by more than 5% from its target weight within that period.

Combining both methods can provide a balance between regular maintenance and responsive adjustments to significant market movements.

5️⃣ Impact of Transaction Costs

Transaction costs can erode the benefits of rebalancing. Therefore, it's essential to factor in these costs when determining rebalancing frequency and thresholds.

If the cost of rebalancing a portfolio is high due to spreads, swaps and commissions, less frequent rebalancing with wider thresholds might be more cost-effective.

6️⃣ Utilizing Technology for Rebalancing

Advancements in technology have made it easier to monitor and execute rebalancing strategies. Automated rebalancing tools can help manage portfolios more efficiently by providing real-time data and executing trades based on predefined criteria. Robo-advisors use algorithms to automatically rebalance portfolios when asset weights deviate from the target allocation. This can be particularly useful where market conditions can change rapidly. I am not a fan of anything automated in trading for us retail traders, but at some point AI may allow us to automate some of the more objective aspects of strategies.

7️⃣ Psychological Aspects of Rebalancing

Rebalancing can be psychologically challenging because it often involves developing the discipline to remain on top of the imbalances caused by hitting targets or accumulating drawdowns. These imbalances may require new positions or hedges and some of these may be under sub-optimal conditions.

Sticking to a systematic rebalancing plan can help mitigate emotional biases. Using predefined rules and thresholds ensures that rebalancing decisions are based on objective criteria rather than emotional reactions.