You've Selected A Great Portfolio - Now What? Best Practices for Rebalancing

Posted by Alex Frey (@alexhfrey )

By now you probably know that setting your portfolio's asset allocation is the most essential act you will perform as an investor.  What you might not have thought about is that after laying a perfect plan and figuring out all the numbers to a decimal point, your portfolio's asset allocation will immediately drift from your carefully-laid target.

Let's say that your initial portfolio is composed of 60% stocks and 40% bonds. During the first year, stocks go down 20% and bonds go up 10%. At the end of the year your allocation will have shifted to 48% bonds and 52% stocks, even though you have done nothing. It might be time to re-balance.

The Costs and Benefits of Rebalancing

It can be psychologically painful to sell asset classes that are going up and buy ones that are going down, but if you fail to do so, you will almost certainly end up taking on far more (or less) risk than you intended too. For instance, a portfolio invested in 60% stocks and 40% bonds in 1926 would have grown to 99% stocks today if it was never rebalanced, according to Vanguard calculations. An investor who failed to periodically re-balance would have seen his or her risk steadily increase over time.

In addition to managing risks, rebalancing can also potentially improve returns over the long run. The reason is that selling assets that have gone up in value and buying ones that have come down in value is a systematic way to buy low and sell high. Rebalancing away from equities after a bull market effectively locks in some of your gains, while rebalancing towards equities after a prolonged bear market effectively puts money into stocks when they are selling at a discount.

Of course, rebalancing has some tradeoffs. 

First, it takes time and attention to monitor your portfolio and figure out when and how to move around money.  

Second, if your investments are held in a taxable account, rebalancing can run up a tax bill since you will have to realize gains on any of the investments that you sell (and you will usually be selling things that have gone up in order to buy things that have gone down).

Third, rebalancing can incur transaction costs.  While discount brokerages charge much less for commissions then they used too, trading costs can still be a significant weight on smaller accounts (and don't forget about the implicit costs).

Strategies for Rebalancing

Re-balancing is a relatively straightforward process; the main thing to figure out is when to do it. There are four approaches:

  1. Calendar-based. Reset your allocations back to "normal" at the same date every quarter, six-month period, or year.  
  2. Threshold-based. Rebalance whenever an asset-class weight is off by more than a previously determined percentage, like 5%. This (along with #4) is the approach we follow with the IvyVest model
  3. Contributions and withdrawals - based. Use contributions and withdrawals to rebalance the portfolio by contributing the most to asset-classes that are currently below their weight and withdrawing from the asset-classes that are currently above their weight.
  4. Model or Market-Based. You may choose to tactically rebalance based on market conditions, particularly if you are using a model such as our ETF Strategy that changes its allocations based on the market. 

The optimal strategy for your portfolio will depend on the size of your account, its tax status, the number of asset classes you hold, and the price that you pay for trades.

For accounts that follow a static asset allocation, simulations show that it is best to use a combination of the threshold and contribution-based approaches. By investing new contributions, interest, and dividends in asset-classes that are underweight, you can reduces the need to make unnecessary trades (since you would be paying the transaction costs either way). Setting a threshold of 5% or so ensures that asset-classes will remain broadly in line with the intended plan.

The main downside to this approach - and the reason that so many turn to a less effective time-based rebalancing strategy - is that it requires a fair amount of attention to effectively implement. The portfolio has to be regularly monitored and assessed to see if any holdings have moved out of line. For most people, this is a huge nuisance. The solution we employ is to use computer models that constantly scour the market and alert us when a portfolio needs to be tweaked. But using a combination of time and threshold-based re-balancing is a good compromise if you don't have computer models available -- for instance, you could check your portfolio on a quarterly basis but only re-balance if the sum of the absolute differences between your actual and target asset allocations is greater than 20%.

Whatever technique you pick to rebalance your portfolio, it helps if you combine it with a tax-loss harvesting strategy to reduce or eliminate the amount of taxable capital gains you may incur.

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By Alex Frey