Definition of portfolio rebalancing
The tendency of professional portfolio managers to put money at risk at the beginning of the year and move out of risky stocks and into safer investments towards the end of the year in an effort to outperform benchmarks and secure a Christmas bonus. It is related to window dressing and the so called “January effect” and the “sell in May and go away” axiom.
Professional portfolio managers’ efforts to maximize their own benefits/remuneration lead them to rebalance portfolios and window dress in predictable ways throughout the year.
The high returns on risky securities around the turn of the year are caused by systematic shifts in the portfolio holdings of professional portfolio managers who rebalance their portfolios to affect performance-based remuneration.
Institutional investors are net buyers of risky securities around the turn of the year when they are motivated to include less well known, high risk securities in their portfolios to try to outperform their benchmarks.
Later in the year, portfolio managers (as they rebalance their portfolios) lock in returns by divesting from lesser-known risky stocks and replacing them with well known safer stocks or risk-free securities, such as government bonds. At the same time, they also switch to stocks or securities they perceive to be less risky and more glamorous in order to spruce up their portfolios (i.e., window dress). The excess demand for risky stocks at the beginning of the year bids the prices of these securities up. As the year draws to a close, the supply of relatively higher-risk stocks grows and the prices decline.