Portfolio Rebalancing
When you select a target asset allocation you will generally own both stocks and bonds in your portfolio. Over time, the percentage of stocks and bonds in your portfolio will drift from your target which changes the risk profile of your portfolio. You can rebalance your portfolio back to your target asset allocation to maintain your desired risk tolerance.
Rebalancing is a risk management strategy.
For example, if your target asset allocation is 60% stocks and 40% bonds and over time your portfolio drifts to 62% stocks / 38% bonds, rebalancing will sell 2% of stocks to buy bonds to return your asset allocation back to 60/40. Over long periods of time, stocks tend to outperform bonds and if you start with a buy & hold strategy of 60/40 and never rebalance, your portfolio style could drift to 70/30 and become more volatile than your risk tolerance allows. Rebalancing back to 60/40 will return your portfolio to your target asset allocation and risk tolerance.
When to rebalance
Every trade made has the ability to enhance or reduce portfolio returns, rebalancing is no exception. While a side effect of rebalancing can be to enhance portfolio returns, the timing of rebalancing is key. A common assumption held by investors is that rebalancing forces investors to sell high and buy low, however that isn't always the case. In the case where stocks and bonds are both lower, rebalancing causes you to sell low and buy lower.
There are two popular strategies used to determine when to rebalance portfolios:
| Time based | Rebalancing is performed at fixed intervals such as annually, quarterly, monthly, etc. Investment advisors often recommend that clients rebalance portfolios on their birthday so that all investors are not rebalancing on the same day. |
|---|---|
| Deviation based | Rebalancing is performed when asset allocation deviates from your target by more than X%. This allows winners to "run" to a certain threshold before selling them. |
How to rebalance
The mathematics to rebalance a portfolio are fairly straightforward. Simply take your portfolio balance and multiply it by your target stock asset allocation (%) and that gives you your target dollar amount for the stock portion of your portfolio. Likewise, use your target bond asset allocation (%) to determine your target dollar amount for the bond portion of your portfolio.
Below is a tool to rebalance a two security portfolio. Simply enter your target stock / bond asset allocation (%), symbols and portfolio balance. Your target dollar amount for each security will be displayed.
Here are several methods you can use to rebalance your portfolio:
- Sell winners to buy losers - Simply sell the security that is over your target asset allocation to buy the security that is below your target asset allocation.
- Buy losers with new money - During your accumulation years you can direct new retirement contributions to the security that is below your target asset allocation.
- Rebalance using dividends - Like the previous method, you can direct dividends to your cash settlement account and use them to buy the security that is below your target asset allocation.
- Sell winners during distribution phase - During your retirement years when you are taking income from your portfolio, sell more of the security that is over your target asset allocation. Once you determine the amount of income you need to take from your portfolio, enter the new balance for your portfolio in the calculator above to see how much your new stocks / bonds balance needs to be.
Automatic rebalancing
Rebalancing takes time to monitor your asset allocation and execute rebalancing trades. Most investors do not have the inclination to rebalance on their own. If you are reading this, you are not the typical hands-off investor. Fortunately, there are mutual funds available that automatically rebalance themselves and allow investors to take a set it & forget it approach to their portfolio. These are balanced funds and target date retirement funds.
Balanced funds attempt to maintain a fixed asset allocation over their lifetime no matter market conditions. Target date retirement funds on the other hand gradually become more conservative (or less volatile) as they approach the target date of the specific mutual fund. In the United States, target date retirement funds are typically the default option in employer's 401k plans. If you are just getting started with investing, a target date retirement fund corresponding to your retirement year is a good choice to start off with. Vanguard offers a variety of balanced and target date retirement funds.
What is the optimal rebalancing strategy?
Which rebalancing strategy is best? It depends. Each approach has the capability to increase or reduce returns, however finding the optimal rebalancing strategy for a portfolio is only knowable in hindsight and is uniquely dependent on the timeframe which is measured.
Rebalancing is not a one size fits all approach for improving your portfolio returns, it is a risk management strategy. That is why there isn't a firm answer on the best strategy for when to rebalance.
Taxes
Here are a few notes about rebalancing and taxes. When you sell a security to affect a rebalancing trade, that sale will have tax consequences in a taxable account. Typically, it is better to rebalance in your tax deferred or tax-exempt accounts. There can be situations where it may be advantageous for you to rebalance in your taxable account to take advantage of tax loss harvesting or tax gain harvesting depending on your specific tax situation. If you do intend to sell a security in a taxable account, it is advantageous to only sell securities that you have held for at least a year and a day to take advantage of lower long term capital gains taxes. You should consult with your tax advisor about the tax impact of selling securities in your taxable account.