There’s an excellent discussion in The Bogleheads’ Guide to Retirement Planning about rebalancing. One of the topics discussed is whether it’s better to:
- Rebalance based on a specific frequency (annually, for instance) or
- Rebalance based on specific tolerance bands–for example, rebalancing if the allocation to a given asset class becomes 10% higher or lower than intended.
Rebalancing Periodically
The primary advantage to periodic rebalancing is its simplicity. “Rebalance once per year” is easy to understand and easy to implement.
The second advantage is that it doesn’t require constant monitoring of your portfolio. Not only is this convenient, but it helps with reducing temptation to panic in a bear market or get greedy in a bull market.
Also, if rebalancing comes with a cost (because you’re investing in a taxable account or because you’re using ETFs and you’re charged a commission for each transaction), rebalancing no more than annually will help keep those costs to a minimum.
The primary disadvantage to rebalancing based on the calendar rather than based on your asset allocation is that it could potentially allow your allocation (and thus your risk level) to get significantly out of whack in the interim.
Rebalancing Bands
The pros and cons of this method are essentially a mirror image of those of periodic rebalancing. Specifically, using rebalancing bands ensures that your asset allocation doesn’t get terribly off kilter during the middle of the year. However, it necessitates checking frequently, which can lead to second-guessing your plans.
Also, as William Bernstein mentioned in his The Four Pillars of Investing frequent rebalancing might actually be detrimental to returns, even before considering costs:
“Research has shown that this tendency for the prior best-performers to do worse in the future and vice versa seems to be strongest over about two to three years. In fact, over periods of one year or less, the reverse seems to be true–the best performers tend to persist, as do the worst. Thus, you should not rebalance too often.”
Hybrid Rebalancing
Some people argue in favor of a hybrid rebalancing method. For example, in Larry Swedroe’s What Wall Street Doesn’t Want You to Know, he proposes the following strategy:
“I suggest using a 5%/25% rule in an asset class’s allocation before rebalancing. That is, rebalancing should only occur if the change in an asset class’s allocation is greater than either an absolute 5% or 25% of the original percentage allocation….The portfolio should undergo the 5%/25% test on a quarterly basis.”
This method sounds reasonable to me. It would probably keep your asset allocation pretty closely in line with your goal allocation, and you wouldn’t have to check your portfolio everyday.
My Rebalancing Method: Annually
It should be no surprise to regular readers that I place a lot of value on the simplicity of annual rebalancing. From where I’m standing, the temptation to tinker that would come with constantly checking my portfolio appears far more threatening than the potential ramifications of my portfolio getting off kilter between rebalancings.
How do you decide when to rebalance?
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{ 12 comments… read them below or add one }
I have a bit of a hybrid method too- I will rebalance yearly to correct any major imbalances, but I adjust where my new investments go monthly. That change helps maximize buying relatively lower assets and helps keep the portfolio from getting too out of wack. As an added bonus for younger investors it may be all the rebalancing you need since your yearly contributions will be a significant percentage of your portfolio.
-Rick Francis
Annual rebalancing is really just one method of using rebalancing bands. Typically there are two components to a disciplined rebalancing strategy, (1) frequency of checks and (2) tolerance bands. For example, someone might look monthly (the frequency) and rebalance only if anything is more than 10% off (the tolerance threshold) their target allocation.
Annual rebalancing is usually just an annual look with zero tolerance.
One other suggestion for those who rebalance annually. Planning your rebalance for around end-of-December/beginning-of-January gives you a little more tax planning flexibility. This is good if you’re planning a Roth conversion or filling out a FAFSA next year or any other a typical situations where picking between income/loss years could be beneficial.
I don’t believe in rebalancing. I decide on a stock allocation by comparing the long-term value proposition of stocks at a given time (determined by how stocks have performed historically at that valuation level) with the value proposition being offered by super-safe asset classes (TIPS, IBonds, and CDs). If stocks offer a likely annual return of 2 percent real per year better than the super-safe classes, I view it as sensible to take on the risks of stocks.
This approach requires occasional allocation changes (once every 10 years on average), but it does not require annual rebalancing. So the transaction costs in general should be a bit less. I view rebalancing as sort of a poor man’s approach to Valuation-Informed Indexing. It provides the same benefit of causing you to buy low and sell high, but far less effectively (in my view!).
Rob
I agree with Dylan. Using a 5%/25% band will actually have you rebalance less frequently than annually, not more frequently.
5%/25% band is hard to breach. Suppose you start with 75% in stocks and 25% in bonds. In a year when stocks go down by 20% and bonds are flat, you end the year with 60 / 85 = 71% in stocks. 5%/25% band says you don’t rebalance yet. Same on the up side. In a year when stocks go up by 20% and bonds are flat, you end the year with 90 / 115 = 78% in stocks. 5%/25% band once again will have you do nothing. Because stocks don’t go up and down by 20% every year, if you use 5%/25% band you will not rebalance every year.
TFB: Not to argue with your conclusion, but doesn’t it matter how frequently you’re checking if you use rebalancing bands?
For example, in your example, are you assuming that you’re only checking annually? Because then of course annual checks + rebalancing bands means less rebalancing than simply annually.
But what if you’re checking monthly, weekly, or daily? (I’ve previously had trouble locating data on returns for periods other than calendar years, so I don’t have the answer to my own question.)
The Journal of Financial Planning published a paper on “Opportunistic Rebalancing,” by Gobind Daryanani CFP®, Ph.D. (January 2008), which may have some of the conclusions you’re looking for, Mike.
http://www.tdainstitutional.com/pdf/Opportunistic_Rebalancing_JFP2007_Daryanani.pdf
@TFB – I wasn’t advocating a specific strategy, just pointing out that annual vs. banding are really just different feathers from the same bird.
I typically advocate either using cash flows (at the frequency at which you actually invest the money), when practical to maintain a target allocation or on an annual basis with nominal (insignificantly small) tolerance for deviation.
Dylan: I just read that paper. Pretty darned interesting! (And it makes sense from a logical point of view.)
Not sure whether the incremental return would be worth the additional effort, but I can see that for some people it could be.
Thanks for sharing it.
“Not sure whether the incremental return would be worth the additional effort, but I can see that for some people it could be.”
… or that it will always be there.
… or that it won’t go the other way.
Heh, that too.
Mike – No I didn’t assume you are only checking annually. 5%/25% is very tolerant. Even if you are checking every day, the intra-year high and low still won’t have you rebalance more frequently than annually. You can download S&P 500 open, close, high, low by year and test it.
TFB: Sorry, then I misunderstood your wording.
And having read the paper Dylan linked to, I must admit that using bands in the 20+% range appears to lead to fewer transactions than I’d anticipated.
I am also a low key kind of person. I review (in detail) and MAYBE rebalance my assets once every year, or after a major (one-off) sort of event, such as after a recession.