Portfolio Rebalancing:
WHAT'S YOUR PLAN?


A portfolio rebalancing strategy is the discipline behind successful portfolio management.  Deciding what investments to buy is only part of managing an investment portfolio.  All asset markets fluctuate, and watching your investments gyrate up and down can become nerve-wracking, to say the least!  You've got to have a long-term plan so that you can ignore the markets and keep your portfolio on track with some peace-of-mind.  This is why you NEED a specific strategy --- it will guide your investment decisions when the economy and/or stock market are going wonky.

Investing decisions should be made by reason, not emotion.  Every successful investing strategy requires some self-discipline.  You've got to ignore the distractions of the media and others' advice, and stick with your plan.

Sticking with your plan is easier when:

  • the strategy is simple
  • the rules are clear
  • it doesn't eat up too much of your time
  • it doesn't require quick actions

  • you know a loss won't wipe you out
  • it doesn't require large commitments of capital

  • you're in it for the long-haul


While your asset allocation is the most significant decision you will make as an investor, your rebalancing strategy is the self-discipline that will help keep you in control of your portfolio
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WHY REBALANCE? 

The primary function of portfolio rebalancing is to control risk.  Different asset classes perform differently over time, causing your portfolio to drift away from your target asset allocations.  Over time, some of your assets will outperform, while others under-perform during a particular market cycle.  Rebalancing controls your risk by moving capital between these outperforming and under-performing assets.

Rebalancing also boosts return.  When you rebalance, you take gains from your out-performers (selling high) and redeploy that money into your under-performers (buying low).  Sell-high/buy-low is a hallmark of disciplined investing.  When the market turns, and it will, you'll have taken gains when you had the chance, and will be loaded up on asset classes set to go up under new market conditions.  Even though it will very likely take some temporary hits along the way, your overall portfolio will trend upwards.


THREE REBALANCING METHODS

(Please note:  this information will only make sense if you've already read the information on Investment Portfolio Management and Allocation Ratios.)

Time-based:  rebalancing at a pre-determined time-frame.  Quarterly or annually is common, and allows you to remain mostly hands-off with your portfolio.  Rebalancing more often doesn't necessarily improve the performance of your portfolio, and the extra transaction  fees must be considered.  However, rebalancing more often may be prudent if your portfolio is aggressive and, therefore, more volatile than a more conservative portfolio.  For individual stocks, use a trailing stop for each stock you own, rather than a rebalancing strategy. 


Threshold-based:   rebalancing when an asset class grows to a pre-determined threshold above its target size.  Let's say you own an ETF of small-cap stocks, which you have determined will hold 10% of your portfolio, and this fund grows to be 10% larger than its 10% target.  (If your portfolio is worth $50,000, this target would be $5,000, and you would sell some off the top when it reaches $5500.)  Sell the gains to bring your position-size in line with your target, and redeploy that capital into, say, a bond fund that is about 10% below its target.  


New Money:  a simple way to rebalance is to put new money and dividends into underweight asset classes.  While this doesn't address overweight classes in your portfolio, it does bring your overall portfolio size up (depending on how much you're adding), affecting whether or not an overweight asset class remains overweight as a percentage of the whole.  What it does do is easily bring your underweight classes nearer their targets with (ideally) one simple transaction.


Portfolio rebalancing is a fairly simple, yet productive, process.  The enemies to following through are psychological:  during bull markets, investors tend to want to stay in (taking on more risk) rather than taking money off the table; during a bear market, investors become risk-averse, fearing putting more money into "losing" asset classes.  Developing the mindset that nice gains won't last (so sell-while-you-have-the-chance) will reduce your risk of loss when the market turns (and it will).  Seeing assets that have declined as being "on sale" (get-it-while-its-hot) will position you for better returns when the market turns again (and it will).  Keep in mind, we're talking about asset classes here, not individual securities.  (Always do your due diligence before purchasing any stock!)

 

YOUNG INVESTORS

College graduates and other 20-somethings are the most likely to fall into the trap of not rebalancing regularly, simply because their investable capital is small, and any decline is more acutely felt.  The short-term volatility of rebalancing in a down market will easily fray the nerves of the new investor, but the long-term benefits outweigh this negative factor, especially for young investors with a long time horizon.  Portfolio rebalancing not only boosts returns in the long run, but it also teaches the young investor discipline, the importance of asset allocation, and how to stick with their plan.


WHERE TO START?

If you are risk-averse, rebalance annually, and check your portfolio as infrequently as possible. 

If you're more hands-on with your portfolio, rebalance quarterly with a 10% threshold.  At the end of each quarter, calculate your asset allocations as a percentage of your total portfolio.  If any allocation has drifted away from its target by 10% or more, rebalance your portfolio.


If you are still regularly adding new money to your portfolio, use the new money to adjust your position sizes according to your targets.  This helps you in rebalancing your asset allocations and is very tax efficient.


Remember:  because of transaction costs, taxes, and just plain old psychology, it is always wise to minimize the frequency of portfolio rebalancing, but don't neglect it altogether.  Figure out which method will likely work best for you and your situation, and stick with it!


NOTE:  the one time rebalancing could potentially ruin your portfolio is if the market is in a very long-term downtrend (i.e. Japan).  There is no way to foresee this ahead of time, but maintaining a sizable position in cash at all times will help reduce loss, as well as position you to deploy some capital when things turn around and opportunities abound once again. 

 

Good investing, faithful steward!




return from "Portfolio Rebalancing" to "Portfolio Management"

see also:

Portfolio Allocation Ratios