Once you have determined your asset allocation and implemented it. What remains to be done is the maintenance of your portfolio as it grows.
Like a gardener tending to a garden, trimming the overgrown branches, weeding, watering and planting new seeds, your portfolio needs care and maintenance to ensure it still matches your risk profile.
There will be periods where stocks will outperform bonds and an initial 50/50 bond to stock portfolio. It might grow into a 30/70 bond to stock portfolio – a more aggressive portfolio which is not in accordance to what you have initially planned.
Rebalancing is the act of adjusting the weights of each asset in your portfolio to the original proportions.
There are two ways to do it:
- Sell the over overperforming assets in the portfolio to buy the underperforming assets in the portfolio. In the previous example (the 30/70 portfolio), I just sell off the stocks to buy bonds to restore it back to 50/50 portfolio
- Without selling, just buying the underperforming asset to restore the original proportions. So in the same example, without selling anything, I buy more of bonds to restore it back to 50/50
The first method follows the adage: Sell high and buy low. You sell all your overperfomlng assets reaping a profit and then use it to buy the underperforming assets in anticipation of future growth. However, this method involves more cost as you need to perform at least two trades: selling and buying. This is done if you are not adding any new cash into the portfolio.
Usually the second method is preferred because of lower costs (you just have to buy, no selling invovled) and it is more tax efficient (The act of selling will incur a capital gain so this applies if there is a capital gain tax). If you are already regularly topping up your portfolio, why not just buy the underperforming assets to restore it to the original asset allocation?
So When To Rebalance?
- Whenever we add cash into the portfolio, this cash should be used to rebalance the portfolio.
- Whenever the portfolio allocation vary beyond a certain range of percentages(constant mixed strategy). If you are not adding new cash to the portfolio, you will have to employ the sell the overperforming assets to buy the underperforming assets method to rebalance.
- Or at a fixed schedule (calendar rebalancing) – monthly, quarterly, semi-annually or annually etc etc… Usually when you are adding cash into the portfolio.
5/25 Rule by Larry Swedroe
- Either if an asset increased or decreased by an absolute 5% of the portfolio. So for a 10% allocation, if an asset had risen to 15% or dropped to 5%
- Or if an asset increased of decreased by 25% of its original allocation. So for a 10% alloaction, if an asset had risen or dropped by 25% of its value, in this case 2.5% which is 12.5% or 7.5% respectively
- Whichever is the lowest is the governing factor. So in this example, it is the 25% rule because a change in 2.5% is lower than 5%.
This is just a guide. If you want to be stricter you may also adjust to a 4/20 rule or if you want to rebalance less often you can adjust it to 6/30.
Order Of Rebalancing
Usually we look at the top levels and work all the way down.
- The highest level is at the broad level of Asset class. For example bonds, stocks, alternatives
- Next level of rebalancing at the international or domestic level of asset class
- The last level are the subclasses like value, growth or sector, emerging markets, small etc.
To have a better picture of the range for each asset class, you may construct a rebalancing table.
Examples of Rebalancing Tables
Rebalancing costs time and money – a matter balancing the trade-offs.
Having a fixed schedule at longer intervals (quarterly, annually) helps reduce rebalancing costs but you must be prepared to have more drift from your original asset allocation.
Having a percentage based strategy (constant mix strategy) helps your portfolio stay closer to its asset allocation but it is more time consuming (you need to monitor more frequently) and costly (more trades).
If you total portfolio is small in value the commissions from each trade could incur significant costs. So, it might be wise to rebalance less frequently.
As your portfolio grows, the asset classes within your portfolio will not grow equally. Over time, your portfolio may no longer match your desired risk level.
Rebalancing allows you to maintain the weightings of each asset in your portfolio to maintain your original asset allocation.
In investing, as in life, there are always trade-offs to be made when employing a certain rebalancing strategy, you must be aware of it and choose one that is suitable.
Balance is key.