A Primer on Portfolio Rebalancing

water-balance-280810Having read about how rebalancing can help you enter the financial markets with confidence irregardless of what may be around the corner, you may be wondering as to what is meant by the term in the first place. It’s fairly simple. Ideally, you are invested in a well-balanced portfolio comprised of specific allocations to certain investment vehicles that have low intercorrelations. Over your investment time horizon, you seek to maintain those allocations in order to control risk while striving to achieve your investment objectives given your particular investment profile.

You may have heard of the ultra-basic 60/40 portfolio, for instance, in which a person is invested in 60% equities and 40% bonds through two or more extremely broad-based low-fee index funds. The percentages represent dollar/yen/whatever amounts of the total monetary value of your portfolio. If you have $10k invested, you’d have $6k in equities and $4k in bonds, according to a 60/40 allocation strategy. A portfolio can, of course, be much more complicated or consist of many more allocations to different asset classes such as real estate or commodities, but you get the idea – the allocations are specific and they are known, and over some amount of time, you seek to maintain them. The act of managing your portfolio by maintaining these allocations over time is what we are referring to with the term, rebalancing.

With the passage of time the markets do all manner of things, causing the allocation percentages you started with to change even if you do nothing. For instance, equities may crash and bonds may appreciate, and your 60/40 portfolio may end up getting turned on its head so that bonds represent a much larger portion of your portfolio than you ever intended. It’s great that you’ve hedged your risk to the equities markets with bonds, but while you’re doing that, you also need to stay true to your long-term investment goals, and besides, things will eventually shift again and equities will go back up while bonds correct – nothing goes up nor down forever.

As your portfolio gets out of whack then, you should be rebalancing to ensure that over your selected investment time horizon, you stand a chance at achieving your investment objectives while staying true to your true risk profile and your own personal investment roadmap. There are three main possible approaches to this as laid out by Vanguard research specialists:

  1. The “threshold-only” approach
  2. The “time-only” approach
  3. A mixed approach

Where the threshold-only approach is concerned, some professionals suggest rebalancing every time your individual portfolio allocations are about 5% out of line with where they were when you initially made your allocation decisions. So, if your 60/40 turns into a 55/45 portfolio, or 55% stocks and 45% bonds, you should sell enough bonds and buy enough equities to pull it back into your 60/40 framework, following this 5% recommendation.

Note how the trigger is a 5 percentage point delta in the total dollar amount invested in each asset class as a percentage of your entire portfolio’s dollar value from where you started – it is not a 5% change in your overall portfolio as in a 5% gain or a 5% loss, nor is it the gain or loss in each asset class. This bears repeating but I’ll phrase it in a slightly different way – you are not tweaking your portfolio based on the gains and losses of each asset class or of the portfolio as a whole. With respect to our conversation here, we don’t care what the gains and losses are right now. What we care about is that if you have $3k invested in stocks and $2k in bonds, you have 60% of the total $5k in stocks and 40% of the total $5k in bonds, a 60/40 split, and moving forward you rebalance your portfolio to maintain that split.

If your portfolio stays at $5k total value (very unlikely over time – it should either go up or down some) but the value of your allocation to equities goes down to $2,750 (now 55% of the total portfolio value of $5k) and the value of your allocation to bonds goes up to $2,250 (now 45% of the $5k), then your allocations are out of whack with respect to where they started. They are each out of whack by 5%. To rebalance, you would sell enough bonds and buy enough stocks that you would bring your allocations back to 60/40.

More likely is a situation where your total portfolio value and the values of each allocation change over time. If your portfolio appreciated to $5,500 from $5k, and your stock portion is now worth $3,850 and your bond portion is now worth $1,650, that’s splendid, your total portfolio value has gone up, but pay attention – your allocation percentages are again out of whack with respect to your original portfolio structure. Given these numbers, you’ve now got a 70/30 portfolio, not the 60/40 you started with. Your exposure to equities, the higher-risk portion of your portfolio, has increased without you touching a thing. In this case, you would sell stocks and buy bonds in order to reset your allocation percentages.

Yes, you would sell some “winners” and buy some “losers”. Observe as well that in this case, your total portfolio gain is 10%, your gain on equities is about 28%, and your loss on bonds is somewhere between 17-18%. Then note that we don’t care about these gains and losses because we don’t rebalance based on these values. We rebalance based on allocation percentages to maintain a certain level of risk exposure and chances of success in attaining our goals, among other things.

In a time-only approach, you rebalance once a period, whatever you choose that period to be. This is at your discretion, but popular options include monthly, quarterly, biannually, and annually. On the rebalance date, you rebalance no matter what the percentage point deltas are between your current allocation percentages and where they started. With a mixed approach, you would rebalance once a period and only if your threshold is met. If your frequency is quarterly, you would check on your portfolio only four times a year and would only rebalance if on those dates your preselected portfolio rebalancing thresholds, say of 5%, had been triggered.

Keep in mind that commonly there are fee and tax implications to rebalancing, so you’ll want to consider those when deciding how often or at what thresholds you want to rebalance. Fees may be advisor or account related, such as whatever your brokerage charges you to execute a trade. Remember that selling assets that have appreciated may result in capital gains tax obligations depending on the account status. Recall also that selling assets that have lost value has tax implications in terms of the losses that you may be able to claim.

Obviously, in order to rebalance you’ll have to pay attention to your portfolio and take action on occasion or hire someone to do it for you, but the benefits are numerous. In addition to the risk-management benefits of rebalancing, establishing a well-diversified portfolio and seeing to its regular maintenance may encourage good investment behavior and help you to avoid some of the trading pitfalls that so many fall victim to, such as letting your emotions dictate your trades. Often, the hardest thing to do is actually to do nothing. We frequently try to micromanage our investments and we usually end up hurting ourselves. Our knee-jerk reactions to some news story or some interview or some personal emotion or some chat with a colleague or friend or family member don’t constitute sound investment practices.

Sound investing consists of developing a solid plan based on quality fundamentals and then sticking to that well-thought-out plan, tuning out the noise as you go. That takes guts, and so does riding out the ups and downs, but the odds of being better off in the long-run, i.e. with a healthy portfolio and positive returns, are in your favor if you do so. Rebalancing according to pre-selected parameters is but one of the tools that can help you enter the markets with confidence, control risk, and accomplish your investment objectives while avoiding bad decisions along the way.

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