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How often should you rebalance your portfolio?

For those who read my last post, you now know you can throw all that textbook investing stuff out the window and go all-in on buying Pokémon cards and dinosaur fossils.

The last post looked at what the rebalancing bonus is, and how best to capture it.

But now we come to the meatier part of the rebalancing debate: how often should we be rebalancing?

 

Contents

 

 

What is rebalancing?

 

Over time, stocks outperform bonds.

If you start with a portfolio which is split 50% in stocks and 50% in bonds, then over time, the stocks will become a larger and larger part of your portfolio. Eventually, the portfolio will up with a 60% weighting in equities and a 40% weighting in bonds. In order to realign the portfolio with your starting asset allocation you’d need to sell some stocks and buy some bonds to get back to a 50/50 split.

This realignment of the portfolio back to its target weightings is known as rebalancing.

 

Why bother rebalancing?

 

If you didn’t rebalance, then, as we’ve seen, your portfolio would eventually become a 60% equity portfolio. Then a 70%. Then an 80%.

Left long enough, your portfolio’s asset allocation would drift further away from your starting asset allocation. And because your starting asset allocation was based on your individual risk tolerance, you shouldn’t want to deviate too far from that mix of assets.

Without rebalancing, your portfolio is likely to become too risky for you.

This is the primary purpose of rebalancing – to keep risk in line.

The second purpose of rebalancing is to increase returns. I’m not talking about increasing returns by chasing the rebalancing bons – as I wrote about in my last article: “What is the rebalancing bonus?”

I’m instead talking about the improved returns through owning a portfolio which stays consistent with your risk profile.

The key point is that unrebalanced portfolios become increasingly risky. With the extra risk caused by not rebalancing, you’re increasing the chances of not being able to stick with your riskier portfolio when the market falls. If you find yourself with a portfolio which has a significantly higher equity weighting than you’re comfortable with and you find yourself staring down the barrel of a market crash, then you’re going to want to panic and make rash portfolio decisions like moving into 100% cash.

So rebalancing keeps your portfolio’s risk in line with your personal risk tolerance, and in doing so boosts returns by increasing the chances you’re able to stick with your strategy.

 

Why is rebalancing difficult?

 

In practice, rebalancing is difficult.

Most of the time you’ll be selling an asset that’s done well (like stocks), and buying an asset which hasn’t (like bonds). That never feels good.

Assets which have strong recent performance tend to have compelling stories which explain their rise. By rebalancing away from those assets, you’re betting against the story, which can be a tough thing to do.

If you’re not confident in how you’ve determined your asset allocation and why it’s appropriate for you, then rebalancing becomes even more difficult. The temptation to let your equity allocation rise will become harder to resist.

Which is why it’s crucial to a) spend the time figuring out your own risk profile, and mapping it to an appropriate asset allocation and b) create your own (simple) Investment Policy Statement, which can act as a periodic reminder of why and how you should be investing.

So, now we know what rebalancing is, why it’s difficult, and why it’s worth the pain, let’s look at how we actually go about doing it.

There are three way to rebalance your portfolio:

  1. Calendar rebalancing
  2. Threshold rebalancing
  3. A hybrid of the two

 

1) Calendar rebalancing

 

The first possible way to rebalance is to do it based on your calendar. i.e. rebalance once a year, once a quarter, or once a month.

Whenever the date comes for you to rebalance, you look at your portfolio and no matter what the weights are, you buy/sell your holdings so they’re brought in line with your desired asset allocation.

The advantages of this method are:

  • It’s simple
  • It doesn’t take much time or thought
  • It requires zero judgement – it’s a simple, rules based approach

The main disadvantage of calendar rebalancing is that if the market has a big move (up or down) over a short period of time, then the calendar rebalancer’s portfolio could remain out of line for some time.

For example, if you were rebalancing on the 1st January every year and the market crashed 50% in mid-February, then you’d spend most of the year with a portfolio which has less in equities than you’d want.

This is where threshold rebalancing comes in

 

2) Threshold rebalancing

 

Threshold rebalancing is, as the name implies, all about rebalancing when certain thresholds are passed.

You check your portfolio periodically, but only rebalance if an asset class has gone over a specified threshold.

For example, you could say you’re only going to rebalance if an asset class moves 10% away from its starting weight in either direction. If you start with 50% equities, you’d rebalance if equities fell below 40%, or rose above 60%.

One advantage of threshold rebalancing is that it can save both time and fees compared to calendar rebalancing.

Because it sets limits, small fluctuations in asset class changes are ignored. This means rebalancing is likely to occur less frequently than under calendar rebalancing, where all asset classes are rebalanced on a set date no matter how much they’ve drifted. Because rebalancing is required less frequently, it means you don’t have to spend as much time putting your buys/sells through, and also means you save on dealing fees.

A second advantage is threshold rebalancing may have a psychological advantage. It makes you more likely to act during a market crash by rebalancing, which is preferable to a calendar-based rebalancing which would likely dictate no action.

Acting during a crash satisfies our need to “do something”. If that action is rebalancing, it means our action is much more beneficial for long-term returns (and actually may enhance long term returns) than by feeling compelled to act and making poor decisions like moving into cash. Rebalancing is better than panicking.

Another further (and related) advantage is that if the market moves quickly, threshold rebalancing is likely to get your portfolio back to your desired asset allocation faster than calendar rebalancing. In our previous example of the market falling 50% in mid-February, if you checked your portfolio monthly using threshold rebalancing, the portfolio would be brought in line much more quickly.

There are a couple of difficulties with threshold rebalancing:

  • How wide do you set your thresholds?
  • How often do you check your portfolio to see whether thresholds have been breached?

Answering question 1 is tricky, but fortunately there’s plenty of evidence to digest, which I’ll dig into below. In general terms, this table from Monevator does a great job at highlighting the main differences between opting for a low threshold vs a high one:

Monevator threshold rebalancing

Source: Monevator

Answering number 2 is an interesting one. Should you be checking your portfolio every day? Every month? Every six months? Once a year?

This is where a hybrid approach to rebalancing comes in.

 

3) A hybrid approach

 

The downside with threshold rebalancing is that you have to check regularly whether the thresholds have been breached. A pure threshold rebalancing strategy requires constant monitoring.

This isn’t practical for DIY investors, nor is it recommended. We want to be checking our portfolios as infrequently as we’re comfortable with, to reduce the chances of self-sabotage.

A hybrid approach takes the idea of periodic portfolio checking from the calendar rebalancing approach, and combines it with threshold rules.

For example, you could say you’ll check the portfolio once a month, but only rebalance if asset classes have drifted 10% from their target weights. Or you say you’ll check once a year, and only rebalance if there’s been more than 20% drift.

So we have a few different approaches – calendar, threshold, and hybrid.

What does the evidence say about each of them? Which one works best?

 

Which is best? Examining the evidence

 

Morningstar

 

Morningstar always have some interesting analysis, so let’s start with them.

They’ve written a few articles over the years on rebalancing, but I think their best is one of their most recent – ‘Why Rebalancing (Almost Always) Pays Off’.

The author, Amy Arnott, set up a simple balanced portfolio composed of a 60% weighting in stocks (S&P 500) and a 40% position in bonds (Bloomberg Barclays U.S. Aggregate Bond index). I’m not sure why Americans are so intent on only ever using US stocks and bonds, but given I’m citing their research I’ll let it go.

Using a starting date of Jan. 1, 1994, Arnott tested various rebalancing frequencies, as well as a static buy-and-hold portfolio. She also looked at a threshold rebalancing strategy which set 5% bands around the starting weights, triggering rebalancing whenever the stock or bond weighting moved at least 5% higher or lower than the target level.

Here are the results for the drawdown analysis:

Morningstar drawdowns

Source: Morningstar

Not surprisingly, the buy-and-hold portfolio (light blue) felt the most pain during the COVID-19 correction in February and March 2020. Simply letting the stock and bond allocations drift from the 60/40 split in 1994 would’ve led to an equity weighting of close to 80% heading into 2020. This equity-heavy posture resulted in the heaviest losses during the market drawdown, with a 27.8% portfolio loss from February 19th to March 23rd.

The other rebalancing strategies all had roughly similar results, across all drawdowns. It didn’t really matter which rebalancing strategy you used, as long as you used one.

Looking at how rebalancing affects volatility, the Morningstar analysis shows all rebalancing strategies did a better job of reducing volatility than buy-and-hold:

Morningstar risk metrics

Source: Morningstar

Overall, annual rebalancing did the best job keeping risk in check, but it’s splitting hairs really.

Looking at the return characteristics, we can see that for the 5, 10, and 15 year periods ending 31st May 2020, the buy-and-hold approach outperformed all the rebalanced ones:

Morningstar return metrics

Source: Morningstar

Investors who let their allocations ride would’ve had an average equity exposure of about 70% during the trailing 10-year period, which paid off during the mostly uninterrupted bull market. The higher equity weighting even made up for the two crashes in the 15 year period – the coronavirus crash and the 2008 crash.

But for 20 year returns, the stats don’t look so good. Investors who opted out of rebalancing would’ve headed into the tech correction in March 2000 with a 79% equity weighting, up from their 60% starting weight. The ensuing crash therefore affected returns much more than for the rebalanced strategies, which rebalanced their equity back to 60% before the crash.

Even over the entire period since 1994, the buy-and-hold approach didn’t pull ahead with higher returns compared with an annual rebalancing strategy.

It’s worth remembering these results are clearly dependent on the date range you’re looking at. Those ranges with more crashes in tend to favour rebalancing strategies (as they reduce equity weights before a crash), and those featuring long periods of strong markets favour buy-and-hold (as the higher equity weight generates stronger performance).

My favourite chart from the article plots the six different rebalancing methods over 15 years on a risk/return chart:

Morningstar risk and return

Source: Morningstar

The graph does a great job in showing that 1) any form of rebalancing is better than no rebalancing from a risk-management standpoint, and 2) the historic returns for each of the rebalancing methods are close enough to make no difference when thinking about which is likely to be best in the future.

Vanguard

 

Vanguard produced an excellent paper on rebalancing recently, titled ‘Getting back on track: A guide to smart rebalancing’.

To kick things off, they ran several simulations produced by the Vanguard Capital Markets Model, looking at the return distributions of rebalanced vs non-rebalanced portfolios, risk reductions from rebalancing, and risk-adjusted returns.

The first simulation they ran looked at the risk reduction benefits of rebalancing. The chart below shows how rebalancing quarterly provided a tighter return distribution than no rebalancing:

Vanguard rebalancing 1

As a result, the second simulation shows the volatility of the quarterly rebalanced portfolio had lower volatility, on average, than one without rebalancing:

Vanguard rebalancing 2

And finally, the risk-reduction benefits of rebalancing tended to outweigh the reduction in return (by constantly trimming equity), meaning Sharpe ratios for rebalanced portfolios were usually higher:

Vanguard rebalancing 3

Turning from simulations to using historic returns, Vanguard then looked at how different hybrid approaches to rebalancing have fared since 1926. Again, US data only, but it’s interesting to see how the monthly/quarterly/annually calendar rebalances fare when combined with 0%/1%/5%/10% thresholds:

The table does a great job of showing that returns, volatility, and average equity allocations were similar no matter which rebalancing frequency was used. They all returned roughly 8.2%, with an 11.5% volatility, and an average equity allocation of 60%. Compare that to the top line, which shows for a non-rebalanced portfolios, returns of 8.74% (slightly higher, as we’d expect), volatility of 14% (noticeably higher) and an 85% average equity allocation (much higher).

Vanguard come to a similar conclusion to Morningstar, and conclude the paper by noting:

“Although a strong case exists for regularly rebalancing your portfolio to improve its risk-adjusted return, no specific rebalancing frequency and/or threshold is optimal for all investors. Generally, more frequent rebalancing will limit the risk in a portfolio to a level suitable for the investment goal, but this potentially comes at the cost of lower returns, increased turnover, and a heavier tax burden in the current period. Just as when investors determine a target asset allocation, they must balance their willingness to accept risk against their expected returns.”

William Bernstein

 

Investing guru and author William Bernstein has a few great bits of research on rebalancing. Two on the rebalancing bonus (here and here) which I went through in my last article, and one on momentum.

The pieces are nice and short – Bernstein is always great in terms of research per minute of reading – but they’re pretty heavy on stats. I’d only recommend going through them if you know your p-values from your t-stats.

To skip to the chase, in his articles on the rebalancing bonus, he concludes that “No one rebalancing period dominates. Monthly rebalancing was best in three cases, quarterly in four, and annual in three”.

In his analysis on momentum in markets, he concludes that stock prices exhibit some momentum over shorter time periods. We know all about momentum, as it’s one of the major factors used in factor investing.

Because he finds evidence of momentum in stock prices, the message he gives is to not rebalance too frequently.

“If asset class prices have a tendency to trend over relatively long periods (say months, or even one to two years) then rebalancing over relatively short periods will not be favorable… For practical purposes, this means no more than annually, and preferably less.

This makes sense, as most academic evidence finds momentum to be pervasive across asset classes, geographies, and time, and tends to work best over one year. Rebalancing away from equities more frequently than that means reducing your allocation to something which is trending upwards, so is likely to hurt returns.

The evidence for the existence of medium-term momentum suggests it’s favourable to rebalance no more often than annually.

Daryanani

 

A 2008 study in the Journal of Financial Planning by Gobind Daryanani entitled “Opportunistic Rebalancing” studied rolling 5-year periods from 1992 to 2004. It tested which rebalancing thresholds performed best (left-hand column) and how frequently an investor should check to see whether a rebalance was required (“look interval” along the top row).

The panel below shows the average rebalancing benefits compared to a buy-and-hold approach for the periods:

Opportunistic rebalancing 1

The author finds the rebalancing bonus from frequent rebalancing was reduced because of 1) trading costs (assumed at $20 a trade – this was written in 2008), and 2) bands which were too narrow reduced the returns from rebalancing because it didn’t allow strong performing asset classes to increase in weight during trending markets. These two factors combined are why the rebalancing bonuses in the top row are mostly negative.

The table shows the bonus peaked at the 20% rebalance band (the best three results are highlighted in yellow), but the returns then decreased once the bands reached 25%.

The benefit of rebalancing drops off after 20% because with bands which were too wide, there were fewer buy low/sell high opportunities, which reduced the rebalancing bonus. The 25% band also resulted in times where the asset allocation drifted more than 5% from the target allocations (which is why the row is highlighted in green).

Additional findings from the study show:

  • Rebalancing return benefits are negative in trending markets (but the drag is least bad when using 20% bands and checking every 1-20 days),
  • Rebalancing provides return benefits in volatile markets like 2000 (again, 20% bands came out on top),
  • Quarterly/semiannual/annual rebalancing bonuses are all similar, and
  • Looking more frequently is better than less frequently

Here’s a good graph which summarises their findings:

Opportunistic rebalancing 2

Overall, the author found the best thing for investors was to set a threshold that’s ‘far enough’ out to allow investments to run during trending markets, but not so far that they run to extremes and bounce back again, without ever triggering a buy or sell trade. He also found it was preferable to monitor the portfolio frequently (but not necessarily to rebalance frequently), which maximised the chances of capturing buying/selling opportunities.

A couple of things to think about with this study, though.

On the downside:

  • We’re only studying 5-year time horizons here
  • The total time period studied is relatively short at 12 years (1992-2004)
  • These are averages of rolling periods, so emphasise the middle years over the tail years

One positive is that the study wasn’t constructed to search for a way to maximise the rebalancing bonus (by using Bernstein’s criteria for maximising it). It was conducted more along the lines of “here’s a pretty normal portfolio, let’s see which rebalancing band is best”. So it’s a good compromise between the heavy set of restrictions required to maximise the rebalancing bonus from Bernstein, and the real-world practicalities of keeping a simple portfolio.

The drawbacks of the study were noted by the Bogleheads, who took the analysis and (in typical Bogleheads fashion) put it under their own microscope.

The Bogleheads

 

The Bogleheads forum, despite being US-centric, is a fantastic resource for DIY investors. I’ve learned more about investing from this site than any other.

When researching this post, Bogleheads came up trumps (again), with this excellent series of posts on the rebalancing bonus.

The author, who goes by the username Siamond, took a similar approach to Daryanani study, and extended both the time period analysed (40 years rather than 12), and the rebalancing cycle examined (20 years rather than 5).

They (I’ll use “they” – I’m not sure whether they’re a “him” or a “her”) designed a spreadsheet to test whether the rebalancing bonus can be observed from past data. They ran all cycles of 20 years contained in the 1980-2020 time interval, starting cycles on January 1st of each year.

The table below is the result:

Bogleheads rebalancing tableSource: Bogleheads

You can see the outcomes of every cycle, per starting year, illustrated by various metrics. In this example, relative bands (20%) were analysed for a portfolio of 50% US equities, 20% international equities, and 30% US bonds.

As you can see by the final portfolio values in the ‘Portfolio Last Yr’ (left-most grey column) and by the annualized returns (‘CAGR’ column, in the middle of the table), the starting date made a large difference for investors (e.g. the 20-year cycles starting in the 1980s did extremely well, due to the ‘roaring 90s’ bull market. But those starting in the late 90s struggled due to the double-whammy of the dotcom crash and 2008). The number of rebalancing events was pretty much the same across cycles, roughly once every other year on average.

Now what about a rebalancing bonus?

The rightmost column provides the annualized returns (CAGR) for an annual rebalancing method. The column to its left computes the difference between annualized returns for relative bands and such annual periodic rebalancing. The average difference was 0.07%, which isn’t entirely negligible, but not that significant either.

The author performed a sensitivity test, starting 20 years cycles every 3 months instead of at the start of every year. The results were only very mildly impacted on average (e.g. by 0.01% or 0.02%), but individual cycles did display some non-negligible variation between quarters of a given year.

“The conclusion of this analysis is that the exact form of rebalancing may not matter much as long it is minimally sensible. It appears that there is not a lot of significant rebalancing bonus to be gained by using more sophisticated methods (e.g. rebalancing triggers/bands), plus part of the bonus is a side-effect of the current asset allocation drifting (typically towards more stocks), in addition of being fairly random.

“The bottom line is that rebalancing is a very useful discipline to stay the course, to stick to one’s investment plan. But any perception of ‘selling high, buying low’ is mostly one’s intuition (behavioral biases included) playing games with one’s brain, while there is just little concrete reality to a ‘rebalancing bonus’ of sort, besides side-effects of the AA drifting away from its target.”

Moving away from Siamond’s analysis, I also did a fair amount of reading through forum posts to get a general sense of what the Bogleheads thought of rebalancing.

Here are some of my favourite takeaways:

1) A significant move in asset allocation requires a huge underlying move in asset class performance. For example, a portfolio with 90% equity requires equities to rise by over 100% for the asset allocation to move to 95% equity.

This post on rebalancing bands by The Finance Buff (which I stumbled across via the Bogleheads) has some excellent graphs to bring the point home:

Market impact on asset allocation 1

It takes a 24% rise in stock prices to move a portfolio from 60% in stocks to 65% in stocks. If you have 80% in stocks, stocks must gain 42% before they bump your allocation in stocks to 85% (assuming bonds are unchanged), and a move from 90% stocks to 95% requires equities to rise by 111%.

Something similar can be seen on the downside:

Market impact on asset allocation 2

Between the range of 30-80% allocation to stocks, it takes a drop of 18% to 25% to move the needle by 5%.

Key points:

  1. Large stock market movements produce surprisingly small changes in asset allocation percentages.
  2. More extreme asset allocations will tend to be the most stable. They require the largest market moves for the asset allocation to change by 5%. Balanced portfolios are likely to see larger drifts in their asset allocation as a result of market movements.
  3. Stocks don’t move up or down 20% or 25% every year. This means using a 5% absolute rebalancing band is quite slow. If you use this method, except in big up or down years, it will probably take several years to trigger a rebalance.
  4. By implication, if you rebalance every year, the change to the allocation percentages must be very small in most years. Say you start with a 60% weight in stocks, by the end of year, it might become 61.3%. The risk and expected returns of a portfolio 60% invested in stocks and a portfolio 61.3% in stocks are practically the same. It’s hardly worth doing anything. You might as well wait until it drifts past 65% or 55%.

2) Daily rebalancing assumes we know what an optimal portfolio looks like for any given risk tolerance. In reality, we probably don’t know the optimal risk/return portfolio allocations to better than 10-15%. There’s also not much different between a portfolio with 60% equities vs one with 70% equities, and the risks of the portfolios will vary over time. So daily rebalancing to a given AA is really an exercise in false precision.

I liked the example one user gave, likening it to being very careful to drive exactly 55 mph on the highway, in an old beaten up car with a speedometer that is only accurate +/- 10 mph, and believing you’re going just as fast as you legally can.

The takeaway is that, given the lack of knowledge of what truly is the optimal AA, there’s no need frequently rebalance back to a target weights.

3) Which rebalancing bands you choose make very little difference to portfolio risk. We’ve seen this finding many times before, but here it is again with a few useful charts.

Here’s what two 80/20 portfolios look like with various rebalancing bands (x-axis) and the resulting portfolio standard deviation (y-axis).

Risk and rebalancing bandsSource: Bogleheads

Over the past 85 years, a 60/40 portfolio with 10% rebalancing band would have had an average allocation of 62% stocks and 38% bonds. That’s a trivially low difference in risk exposure.

Take a look at the following chart of maximum crisis drawdowns for a 60/40 portfolio over the past 50 years with different bands. If there’s a case that one band is systematically and objectively superior to another, I don’t see it:

Drawdowns and rebalancing bandsSource: Bogleheads

So the rest of the Boglehead evidence points to the ideas that:

  1. Big market moves have a surprisingly small effect on your asset allocation
  2. We don’t know what an ‘optimal’ portfolio looks like, so we shouldn’t be too bothered with a bit of AA drift
  3. Which rebalancing bands you choose makes very little difference to portfolio risk

By now we’ve looked at a pretty wide variety of rebalancing studies.

Most of these studies and findings are well-known in the investment industry. So it’s telling to see how the experts rebalance their own portfolios.

 

What do the experts do?

 

Talk is cheap.

The real test of who thinks which approach is better is to know how they rebalance their own portfolios.

So I’ve gathered data from a smorgasbord of experts who’ve talked about how they rebalance their own portfolios, either in articles or books they’ve authored.

Here are the results:

David Swensen

 

David Swensen, Yale University’s late endowment CIO, was in favour of rebalancing daily.

In his book Unconventional Success, he had this to say about rebalancing:

“Over long periods of time, portfolios allowed to drift tend to contain ever-increasing allocations to risky assets, as higher returns cause riskier positions to crowd out other holdings. The fundamental purpose of rebalancing lies in controlling risk, not enhancing return. Rebalancing trades keep portfolios at long-term policy targets by reversing deviations resulting from asset class performance differentials. Disciplined rebalancing activity requires a strong stomach and serious staying power.”

In terms of what that means in practice, Swensen rebalanced Yale’s portfolio every day. His logic was that if there are no costs, then why wouldn’t you want to keep your portfolio consistently in line with your risk profile? As he says above, rebalancing isn’t about maximising returns, but about manging risk. If his portfolio is supposed to be a 60/40 blend of stocks and bonds, and tomorrow it moves to 61/41, then if it’s free to do so, why not rebalance?

He was also a fan of the rebalancing bonus gained from being able to rebalance daily:

“As a matter of course, every trading day, Yale estimates the value of each of the components of the endowment. When marketable securities asset classes (domestic equity, foreign developed equity, emerging market equity, and fixed income) deviate from target allocations, the university’s investment office takes steps to restore allocations to target levels. In fiscal year 2003, Yale executed approximately $3.8 billion in rebalancing trades, roughly evenly split between purchases and sales. Net profit from rebalancing amounted to approximately $26 million, representing 1.6% return on the 1.6 billion equity portfolio.”

David Swensen, Unconventional Success, p. 198.

Now, Swensen lived in a different world to you and I.

His endowment’s transaction costs were miniscule, he didn’t have the burden of taxes to consider, and his returns weren’t adversely affected by looking at his portfolio every day.

For the regular investor, our transaction costs are much higher, many of us have to consider capital gains taxes, and we shouldn’t be looking at our portfolio every day – three excellent reasons not to rebalance every day. Plus, if it’s not your job, then why would you want to spend time every day faffing around with rebalancing?

Larry Swedroe

 

Larry has his own method of rebalancing, popular amongst the Boglehead crowd, which he’s dubbed the “5/25 rule”.

His method says you only need to rebalance when an asset class is off by an absolute 5%, or a relative 25%, whichever is less.

Following this rule, if your target equity allocation is 60%, you’d rebalance anytime it was off by an absolute 5% — that is, above 65%, or below 55%. For asset classes with smaller targets, the “relative 25%” figure is more useful. If you’ve allocated 10% to emerging markets, you’d rebalance any time this fund dipped below 7.5% or rose above 12.5% (because 2.5% is 25% of 10%).

I like this as a compromise for the threshold method of rebalancing. It works particularly well if you have a mix of funds, some with large weightings and some with small. Combined with the periodic checking used for calendar rebalancing, it looks like a good option for most investors.

Michael Kitces

 

US personal finance guru Michael Kitces weighs in on the optimal rebalancing method in his article, ‘Finding The Optimal Rebalancing Frequency – Time Horizons Vs Tolerance Bands

He goes through the Daryanani and Vangaurd studies we’ve talked about above, and ultimately comes down on the side of threshold rebalancing over calendar. Specifically, he favours relative threshold bands – i.e. instead of using a 20% absolute threshold either side of 50% meaning 30%-70%, using a 20% relative threshold of 40%-60% (because 20% of 50% is 10%).

This means the investment must effectively outperform all the others by approximately 20% on a relative basis, to cause its relative weighting to drift above or below the thresholds (regardless of the weighting it started at).

The benefits of this approach, in his words, are:

“Setting the thresholds for target allocation bands on a relative basis – e.g., 20% of the target weighting itself – creates a mechanism where any one particular investment that moves to a high or low extreme will be sold or bought accordingly, because its performance is so different than everything else. But rather than forcing a rebalancing transaction for all investments in the portfolio – whether necessary or not – as would occur with time-based intervals for rebalancing, a relative threshold to the target weighting will just trigger rebalancing trades for the exact investment that moves away from the rest. This will trigger a “trim” to an investment in the midst of a strong run, and a purchase for one that has just crashed (relative to the others).”

Rick Ferri

 

Investment adviser, author, and Boglehead Rick Ferri takes a pragmatic approach to rebalancing in his book ‘All About Asset Allocation’ (p46):

“The rebalancing strategy that is best for you is the one you will implement without hesitation or procrastination. What works for you may not be what works for someone else. It does not make much difference, as long as it is done… Annual rebalancing is simple and cost effective, and it takes only a little time each year to implement, which means that you are more likely to get it done.” P46

Tim Hale

 

Tim Hale, the author of ‘Smarter Investing’ (which is required reading for any UK DIY investors), is a fan of the relative threshold approach:

“Some investors rebalance every year, which may be reasonable in steady markets. However, it probably makes sense to set a target for rebalancing, for example when the risky assets/defensive assets mix has moved by 10% or more.” P188

Lars Kroejer

 

Ex-hedge fund manager and author of ‘Investing Demystified’ takes a similar approach to Tim Hale, but advocates absolute bands of 10% rather than relative:

“After you determine your initial mix of the portfolio, have an idea of what kinds of bands you are happy to operate within before rebalancing. If you are more than 10% out of sync, that is probably a good time to rebalance.” P152

Burton Malkiel

 

Economist Burton Malkiel, author of seminal passive investing book ‘A Random Walk Down Wall Street’ keeps things simple:

“I would recommend rebalancing your portfolio annually so as to keep the risk level of the portfolio consistent with your tolerance for risk.” P378

 

Real world considerations

 

By now we’ve seen what the evidence has to say about rebalancing, and have a decent amalgamation of expert opinions.

But when reviewing academic evidence, it’s all too easy to forget about the pesky real-world. Sadly we live in a time with taxes, periodic additions/withdrawals from our portfolios, transaction costs, and limits on our free time.

So how should all these factor into our rebalancing decisions?

Tax

 

In the UK, any time you sell an asset above what you paid for it outside of a tax wrapper, you are liable for capital gains tax. There is a CGT allowance, but anything above that suffers tax at 20%.

This means rebalancing becomes considerably less attractive for those investing outside their pension or ISA. As a result, it might not make sense to rebalance as frequently if a theoretical reduction in risk results in a very real tax bill.

For those investing outside a wrapper, it therefore makes sense to monitor your CGT allowance carefully, rebalance using new money rather than selling, and carry forward any losses.

Portfolio contributions and withdrawals

 

Very few portfolios in the real world have zero contributions or withdrawals.

Either we’re constantly topping them up to save towards retirement, or we’re withdrawing from them to fund our spending once we’ve retired.

When adding cash into your portfolio, rather than investing it in line with your target asset allocation, it can be used to buy more of the asset class which is underweight. Similarly, when withdrawing from the portfolio, you could sell down the asset class which is overweight.

Given these additions/withdrawals typically occur once a month, the portfolio is likely to be at least partially rebalanced much more often than many of the simulations used in the evidence have suggested.

If you’re in the situation of regularly adding to/withdrawing from your portfolio, then the chances are your AA will be kept much closer in line with your target AA than someone who had no contributions or withdrawals.

This means it may end up being the case that for those people adopting this rebalancing strategy, a ‘hard rebalance’ back to target weights is a much less frequent occurrence.

The rebalancing effect of contributions/withdrawals is dependent on their size relative to the size of the portfolio. A small portfolio with large contributions will be kept much closer to target weights than a large portfolio with small contributions.

In practice, periodically checking the portfolio and only rebalancing if a threshold has been exceeded will likely lead to fewer trades being required and should keep both portfolio risk and transaction costs in line.

Transaction costs

 

Speaking of transaction costs, this is a big one as a rebalancing consideration.

As interesting as it is to consider the effects of daily rebalancing on a portfolio’s return characteristics, in practice the presence of not-insignificant transaction costs makes frequent rebalancing completely un-economical for the average investor.

Even the so-called ‘free trading’ apps will have some sort of transaction cost. Whether that’s through a wider spread or higher FX fees, everyone pays to buy or sell.

It’s up to each individual investor to weigh up the benefits of regular rebalancing against their particular transaction costs. How much trading costs eat into returns will depend on your broker, what your portfolio holdings are, and the size of your portfolio.

I would say that nobody should be rebalancing their portfolio every day. But the decision to choose monthly, quarterly, semi-annually, or annually should be impacted by how expensive it is for you to rebalance.

For those using a per-trade broker (as opposed to a monthly-fee broker), with many portfolio holdings, and a small portfolio size, rebalancing should be as infrequent as possible to minimise transaction fees. But for those with large portfolios, few holdings, and lower broker costs as a % of their portfolio, rebalancing more frequently isn’t so prohibitive from a cost standpoint.

Free time

 

This is something which I think is overlooked in most rebalancing debates.

Personally I don’t want to spend much time thinking about my portfolio, which is why I’ve designed it to take as little effort as possible to maintain. The less I think about it, the less I’m inclined to tinker and inevitably make it worse.

Because investing is one of those few areas of life where time spent (input) has no correlation to returns (output), I can see no benefit to me sacrificing what little free time I do have faffing around with figuring out whether I need to rebalance or not – and if I do, putting the trades on.

I’d much rather spend my most precious resource – time – on things I enjoy.

But not everyone’s the same. There are some masochists out there who enjoy rebalancing every day.

Matt Hollerbach, who runs the blog ‘Breaking the Market’ has a fascinating strategy, based on rebalancing as frequently as possible. Clearly he loves rebalancing and is happy to do it every day.

Personally, I’d rather ignore my portfolio for as much of the time as I’m able to.

 

Summary

 
  • The primary purpose of rebalancing is to manage risk.
  • Through ensuring your portfolio’s risk is appropriate, you’re also increasing returns through designing an asset allocation you’re able to stick with when the market crashes.
  • The rebalancing bonus, which also increases returns, does exist in theory – we saw this in my last post. However, it requires a high level of knowledge about the future, requires some significant portfolio adjustments to try and capture it (with no guarantees, of course, that you’ll actually earn any bonus).

There are three main methods of rebalancing:

  1. Calendar
  2. Threshold
  3. Hybrid

What the evidence says about which method is best:

  • Morningstar: It doesn’t matter – just pick one.
  • Vanguard: It doesn’t matter – just pick one.
  • William Bernstein: No more than annually.
  • Daryanani: 20% threshold, rebalance frequency is irrelevant (as long as checking is frequent)
  • Bogleheads: It doesn’t matter – just pick one.

What the experts do:

  • David Swensen: Calendar – daily (assuming you’re managing a tax-exempt multi-billion dollar endowment, and are confident your asset allocation is ‘optimal’).
  • Larry Swedroe: Threshold – using the “5/25 rule” (only rebalance when an asset class is off by an absolute 5%, or a relative 25%, whichever is less).
  • Michael Kitces: Threshold – relative bands over absolute.
  • Rick Ferri: It doesn’t matter – just pick one.
  • Tim Hale: Threshold – 10% relative bands.
  • Lars Kroejer: Threshold – 10% absolute bands.
  • Burton Malkiel: Calendar – annually.

Real world considerations:

  • For assets outside tax wrappers:
      • Rebalance less frequently to minimise CGT taxable events,
      • Use new contributions to rebalance rather than selling,
      • Carry forward any losses from rebalancing.
  • Rebalancing using regular contributions or withdrawals means you’ll likely need to rebalance less frequently, and will reduce transaction costs.
  • How much trading costs from rebalancing eat into returns will depend on your broker, what your portfolio holdings are, and the size of your portfolio.
  • Some rebalancing strategies require more time for monitoring and trading than others. Consider how much time you want to spend on your rebalancing strategy.

 

Conclusion: which is the best rebalancing strategy?

 

The evidence comes down clearly on the side of “it doesn’t matter which strategy you choose – just pick one and stick with it.”

For a simple index tracker portfolio, there’s no evidence of any single method of rebalancing being superior to any other – either for maximising returns or reducing risk.

This is clearly shown through the variety of rebalancing strategies used by the experts. Some rebalance daily, some no more than annually. Some use calendar, some use threshold. Some use relative bands, some use absolute bands.

Ultimately, which strategy you should use comes down to personal preference.

Some investors may prefer to use an annual rebalancing process for its simplicity, and find comfort in not acting if there’s a selloff during the year.

Others will prefer the more reactive methods based on rebalancing triggers using a threshold approach.

Personally, I contribute a large amount to my portfolio every month relative to its size. As I mentioned above, the frequency of rebalancing depends on the size of the contributions/withdrawals relative to the portfolio’s size. My level of relative contributions mean I have to rebalance very rarely. I’ll still check my allocations monthly (as I check my portfolio each month to keep track of performance), but in reality rebalancing is only required once every few years.

If I were managing a portfolio with no cash inflows or outflows to help with rebalancing (and I wasn’t keen enough on investing that I’d check my portfolio monthly anyway), then I’d probably plump for a hybrid approach, using relative thresholds and checking annually.

A pure threshold approach is great, but requires constant checking. We all know we’re our own worst enemies when it comes to investing, so it’s best to design a system which reduces the amount of time we spend looking at our portfolio.

On the other hand, calendar rebalancing seems a bit too rigid for my tastes. Rebalancing everything back to target weights each year doesn’t seem like a great solution, because:

  1. Big market moves result in surprisingly small changes in asset allocation (see the Bogleheads evidence above), so the chances of seeing meaningful drift over one year is small,
  2. As a result, you’re likely to be executing a higher number of pretty small trades, which increases the drag of transaction costs, and
  3. None of us are able to gauge exactly what our ‘optimal’ asset allocation is to any degree of accuracy anyway, so being frequently forced to rebalance back to this target weight seems like an exercise in false precision.

That’s why I prefer a hybrid approach. To me, it strikes a good balance between requiring minimal oversight, while at the same time ensuring portfolio risk remains appropriate, as well as reducing transaction costs.

But that’s just, like, my opinion, man.

At the end of the day there are no wrong answers here, as long as you stick to some form of rebalancing approach.

There’s no way to know in advance which method will end up coming out ahead in terms of risk-reduction or return maximisation, and they’ve all behaved pretty similarly in the past anyway.

So just find an approach which gels with your own portfolio and your own investment philosophy and stick with it.

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gaz
1 month ago

Thanks for the article. It was very informative, as I’m still learning all this.

To me, the missing 4th option would be funds like Vanguard’s Lifestrategy which do the rebalancing for you. Is there any data on how they compare to the 3 rebalancing strategies?

My own situation is different. I’m 100% in equities just now, as I’ve no issue with risk as long as I understand it, and retirement is a long, long time away.
Your table above showed Buy and hold struggling against rebalanced portfolios over 20/25 years, despite presumably having a greater equity proportion. Do you think something like a rebalanced 80/20 split would ever outperform a 100% equity portfolio in the long term (20-30 years)?
I would guess the 80% exposure doesn’t really shelter from crashes that much compared to all in equities? And by the time you’ve enough bonds in your portfolio to make a meaningful difference in dips, you miss out on most of the long term equity gains?

Torsten
1 month ago

Thanks for another thorough piece of research, and for the helpful conclusions. So far I have rebalanced by occasionally adjusting my monthly savings plan, which has no costs or tax implications. It looks like there is no evidence to suggest I should pick a more laborious approach, which is nice!

I am now wondering whether to give up the percentage target for bonds (mine is 15%) and set it to a £ value: the amount of money that, even with bonds falling 50%, would complement my cash savings to see me through at least three years with zero income. As I am close to that financial target now I could stop rebalancing soon and switch my regular investment to 100% stocks to maximise long-term return until it is time to reduce my stock exposure leading to retirement.

Does that make sense, or is there still a case to stick to a % target and keep on rebalancing?