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October 06, 2022

What is Rebalancing and Why is it Important?

What is Rebalancing?

Rebalancing is the act of adjusting positions so that they remain within bounds you may have put in place (i.e., no more the X% allocation into any one asset).

Why is Rebalancing Important?

Rebalancing is key in any portfolio management with a focus on reducing risk through diversification. The strategy prevents concentrated exposure in any one position, especially high-risk assets.

There is a common saying, high risk leads to high reward. For positions that are risky, that often entail large price movements. This is most apparent in crypto where large multiple movements are quite common, where you can have a token 10x in a day. Ideally, you will take profits before there is a correction, and that’s where rebalancing becomes very important.

How does this help me?

Let’s go with an example - at the onset of a new portfolio say you invest 20% in each of the following tokens: ETH, UNI, SUSHI, BTC, CRV. The portfolio is worth $1,000 at launch. Over the next week, UNI grows by 10x due to market demand and a new protocol launch, while the remainder of the portfolio is relatively the same. You now have a portfolio valued at $2,800 - and UNI makes up ~71% of your portfolio.

This is a great win but you now have excessive exposure to UNI. It is unlikely you would want to have 70%+ of your portfolio exposed to any one token given its volatility. This is a great opportunity to rebalance, reducing your UNI exposure back down to 20%. This allows you to take some profits on UNI while re-investing in your other tokens or expanding to a larger subset. Ultimately, diversifying your holdings and reducing overall risk. The exposure per a token or exact method of rebalancing is arbitrary.

Wow, this sounds great!

Yeah, it is. The punchline is that rebalancing allows you to take profits on positions that have done well, keep your exposure to any one token under control, and diversify your holdings to reduce the risk of the overall portfolio.

This is a core reason why at Ember we have rebalanced certain structured portfolios, especially The Originals where it's 50/50 ETH and BTC. If we were to look back a few months, a portfolio that just held would be up ~6%, while a portfolio that was rebalanced once a month would be up ~16%. This may not always be the case but usually, a good rule of thumb is that if one asset runs, take profits and rebalance into another while keeping your exposure to any single asset under control.

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