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Is Rebalancing Market Timing?

A reader writes in, asking:

“Some people rebalance once a year, others rebalance either more times a year, or when a particular fund goes up or down more than a certain percentage. When, if ever, does rebalancing become a form of market timing, or is all rebalancing, regardless of when it is done, a different name for market timing?”

Personally, I dislike the term “market timing.” It includes so many different things that I don’t think it’s very helpful as a descriptor. For example, market timing could include:

  • Day trading back and forth between cash and a total market ETF (which is clearly unwise for most people), or
  • A one-time decision to move a portion of one’s portfolio to an inflation-adjusted lifetime annuity because recent returns have been good and interest rates are high (which, depending on circumstances, could be a perfectly wise decision).

In other words, I don’t think it’s particularly useful to ask whether rebalancing is a form of market timing. I think it’s more useful to get right to the point and ask if you should rebalance your portfolio and, if so, when you should do so.

What Would Happen if You Never Rebalanced?

In my view, the primary goal of rebalancing is to keep the risk level of your portfolio approximately where you want it to be. If you never rebalanced, it’s likely that stocks would eventually dominate your portfolio because of their higher long-term returns, thereby causing your portfolio to get riskier and riskier as you age. For most people, that would not be a good thing.

And if you’re going to be rebalancing, you obviously have to settle on some plan as far as when to do it. And you have to choose between the various options somehow.

When to Rebalance

One way to choose between rebalancing methods would be to select based on ease of implementation. That might lead you to rebalance, for example, every year on your birthday (woohoo! rebalancing party!) or to use an “all-in-one” fund that rebalances for you automatically.

Or, you could go about the risk-control directly, checking your portfolio on a regular basis and rebalancing any time your asset allocation is out of whack by more than a certain amount. For example, in his Only Guide You’ll Ever Need for the Right Financial Plan, Larry Swedroe suggests rebalancing when a holding is off by an amount equal to 5% of your portfolio balance or 25% of the holding’s intended balance.

Alternatively, you could choose based on some rationale for why a given method might earn slightly better returns than another method. For example, you might note that stocks have historically shown momentum over periods of less than one year, so you choose to rebalance every two years rather than rebalancing more frequently.

I think any of the above rebalancing strategies would be perfectly reasonable — even if they could be referred to as market timing. Most important, in my opinion, is to pick a method and stick with it so that you know your asset allocation (and therefore, the risk level of your portfolio) will not get too far out of whack.

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Comments

  1. At first, I tried to re-balance once a year, but that seemed fidgety to me. So now I’ve been re-balancing when I add new money to my portfolio. If fixed income is lower than its target allocation, I add enough of that to correct it and then look at US vs. international stocks. This also seems to work better with the occasional lump sums and then I’m never selling shares.

  2. Assuming a general uptrend in equities (and why invest in equities at all if you don’t make this assumption?) your balance will move towards ever more and more equities and ever higher and higher risk. Lets assume agreement on that point, at least for starters.

    BUT! What is an acceptable level of risk? It probably depends a great deal on the size of your portfolio. So to the extent your equity level increases the risk it also increases the appropriate amount of risk.

    Another point of view, and one which may argue against our assumed agreement above (increased equity allocation resulting in increased risk). Some argue that It’s not the nominal percentage of equities that determines risk, but the relationship of that percentage to the overall market’s equity allocation of invertible wealth. If your equity allocation is drifting higher, so is the market’s. Both you and the market are floating on the same ocean.

    In both of the above cases, things may not be one-for-one, nor even in a linear relationship, but both should tend to work AGAINST the need for rebalancing.

    At least those are my half-baked thoughts!

  3. What I call “market timing” is allocating assets based on one’s assessment of the current “state of the market” … for example “I’m buying stocks because it looks like the market is beat-up and I predict that stocks have nowhere to go but up….” Re-balancing on the other hand has no such aspect. It is (or at least should be) based on a plan such as re-balance on a specific date every year, or re-balance when my asset allocation is off target by x%… regardless of what anyone thinks of the current state of the market or predictions for the future. Guesswork, predictions and emotions are completely ignored.

  4. Mike, I have read several books and many papers on Asset Allocation and re-balancing and you have once again distilled a topic to its essence. Thanks for that clarity!

    Some studies have shown higher returns because [optimally] rebalancing is buying depreciated [lower-cost] assets and selling appreciated [higher-cost] assets, but – like most investing strategies – “it depends”: “Cheap” assets can be on the way to getting much cheaper. Only by luck will we ever make sales/purchases at a market turning point, so we should not even try, for the results for both amateurs and professionals are dismal!

    The real best thing about Asset Allocation / re-balancing / risk management is not the potential for slightly better returns [or not], it is about helping us “stay the course”, both when markets are zooming up or when they come crashing down.

  5. Good post. I don’t consider rebalancing to be market timing in any way, shape, or form. I concur that it is an important risk control tool. I generally use an approach similar to Swedroe’s. For clients with retirement plans I generally have them set their account to auto-rebalance twice per year. We might do it in-between if warranted.

If you want to discuss this article, I recommend starting a conversation over at the Bogleheads investing forum.
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