In our last of three articles on setting investing rules for ourselves, we’re going to tackle the subject of rebalancing your portfolio. Previously, we discussed how to buy individual stocks and knowing when to buy stocks. Our goal with this series is to develop a framework of guidelines and rules to protect you from you. Data shows the best investment returns come with a systematic approach to investing. Some investors have this systematic approach forced upon them via a 401(k) type plan, and others need to establish the framework themselves in order to prevent random moves based on emotion and news headlines.
Rebalancing your portfolio typically refers to the simple act of modifying your investment portfolio back to a target allocation when various market forces move that allocation away from its original target. For example, if you set out with a 70/30 stocks/bonds split, and you saw a major move up in stocks, your allocation might be closer to 80/20 now. In such a scenario, you could “rebalance” by selling some stocks and moving that money into bonds in order to get back to a 70/30 split.
But while on the surface, rebalancing seems like a very straight forward and logical concept, it can get more complicated quickly once you start thinking through the actual mechanics of it. For instance, should you rebalance once a month or once a year? Should you rebalance any time the target allocation gets over a certain threshold of being “out of whack?” What about when you factor in contributions during accumulation phase or withdrawals during retirement phase? Let’s try to bring some clarity to these types of questions by digging deeper into rebalancing. As always, our goal is to establish some rules for ourselves to remove as much decision making in the moment as possible.
What is the purpose of rebalancing your portfolio?
Ultimately, rebalancing aims to address risk. Investors typically establish a target allocation of stocks/bonds in order to find a sweet spot of return and risk based on their age and goals. As markets move and our assets change in value and if we get too far from that target allocation, we’re no longer looking at the same risk profile as when we set up the allocation. By rebalancing, we can get back to the appropriate level of risk.
Are there any downsides to rebalancing? In a paper by BTS Funds, they noted that a 60/40 portfolio in March 2009 would grew to a 84/16 portfolio at the end of 2019. This is obviously a perfectly timed window of the start and end of a decade-long bull market (timing that no investor accomplishes in real life), but the example is instructive to show how an allocation moves during a bull market.
One take-away here is that had an investor been rebalancing regularly through the 2009-2019 bull market, their overall returns would be lower. But investing is not just about returns. Investing is also about protecting capital and avoiding excessive draw downs. By rebalancing, that investor is also more protected from the drawdowns that occurred in relation to the coronavirus in March 2020. In general, if an investor expresses concern about missing out on upside by rebalancing, they are typically ignoring the risk side of the equation.
How often and when should you rebalance your portfolio?
The following approaches go from more conservative/traditional towards more aggressive strategies that inch closer to market timing.
Rebalancing strategy no. 1 – Fixed interval rebalancing
The simplest form of rebalancing is the idea that you rebalance on a regular basis based on time intervals. The most common approach here might be annually. For instance, you rebalance on January 1st every year. Or it could be twice per year on July 1st and January 1st. By going with the time-based approach, you will tend to avoid rebalancing based on temporary sharp moves in the market both up and down. Over time, sharp moves tend to get smoothed out, and this approach might result in fewer rebalancing moves based on the strategy forcing you to wait until a pre-determined time.
If your rebalancing is occurring in taxable accounts, then incurring taxable events needs to be part of your thinking. If you are incurring taxable events, limiting the number of times you rebalance can be a good idea. Hence, you might opt for a simple once-annual approach.
Rebalancing strategy no. 2 – Threshold rebalancing
Rather than rebalancing based on time intervals, another option is the threshold approach. This strategy says that if you exceed a certain threshold away from your target allocation, then rebalance in order to get back towards your target allocation. So, if your target allocation is 70% stocks / 30% bonds, you might decide your threshold is 5%. If a bull market in equities leads to your allocation moving to 76% stocks / 24% bonds, then your rule would say you should now rebalance back toward the 70/30 split by selling equities and putting that money into bonds.
You can also do a slightly tweaked version of the threshold approach by having a different threshold for your equities side compared to your bonds side. Since equities will move around a bit more, maybe your threshold is 10% for equities, 5% bonds. In the scenario we mentioned above, if your allocation moved to 76/24 as a result of an equities bull market, you would not rebalance because the equities have not gone up more than 10% above target allocation. Now, you might ask, but bonds are more than 5% away from target allocation of 30%, why wouldn’t you rebalance? In this type of set up, we’d use the threshold on the portion of the portfolio that has gone up. Since stocks moved up, you use the 10% threshold. If the opposite occurred and your portfolio moved from a target portfolio of 70/30 to 64/36, then you would indeed rebalance as bonds have moved more than 5% above the target allocation.
Rebalancing strategy no. 3 – Modified schedule rebalancing
The following rebalancing plan is mostly relevant if you’re able to begin implementing at the start of a new bull market. So, if you started paying attention to your investments in, say, 2017 (8 years into a bull market), it probably makes sense to use a different approach.
The goal of this strategy is to adjust the rebalancing based on how far into a bull market we are. Obviously, you never know for sure what stage you’re in of a bull market, but we’ll do our best to put a reasonable strategy in place even with the unknowns.
Our first rule here is that if we’re within a few years of a major market crash (30%+), we are not going to rebalance towards bonds. The rationale here is that we want to let our equities position run a bit. Now, if we get some corrections during this time, we will rebalance from bonds into equities, but never equities into bonds during this initial phase.
Next, if we’re out of the initial phase of a bull market (you can determine what should be the initial phase – maybe 3-5 years), then we implement threshold based rebalancing as outlined in strategy no. 2 above.
Lastly, if the Federal Reserve initiates a new rate cutting cycle (can be indicative of a latter stage of the bull market), let’s tighten up our thresholds by maybe cutting them in half, and rebalance even more frequently (make sure you consider tax ramifications!).
Since this approach is a bit more aggressive than the above strategies, it’s important to decide the rules you’re going to implement ahead of time and stick to them as things unfold.
A different approach
Rather than focus on maintaining a target allocation and rebalancing at various times or events, you might consider a target allocation shift through the lifespan of a bull market. This is closer to market timing, and as such, it introduces much more uncertainty, but let’s try to map out a potential strategy with rules to follow.
If you’re in accumulation phase and not near retirement, you might take a more aggressive approach with your investing. This also assumes that you’re positioned aggressively at the start of a new bull market. For instance, if we’re coming off a recent market crash and a new bull market is beginning, ideally you’re heavily weighted towards equities with maybe a 90-100% equities allocation and 0-10% bonds. In an ideal scenario (you never get ideal scenarios), you would be 100% stocks then as the bull market wanes, you would be at your target allocation of, say, 70/30. The question is how do you know when to make these adjustments? We need some rules to follow otherwise our execution will be left to emotion and headlines.
Approach no. 1 – Shift your allocation 5% per year until you reach your target allocation
This is a simple approach. Start with a heavy allocation towards equities (say 90%-100%), then move at the end of each year 5% towards your target allocation. 100/0 to 95/5 to 90/10 to 85/15, etc.
Approach no. 2 – Do nothing for 2-3 years, then shift your allocation 5% per year until you reach your target allocation
In this slightly more aggressive version of the first approach, we’re going to leave our allocation aggressive for 2-3 years, then start shifting 5% per year. The idea here is to let the stocks run for a few years without rebalancing.
Approach no. 3 – Shift your allocation a smaller amount (2-3% per year), but when the Fed begins cutting rates, move immediately to your target allocation
If you’d like to remain in a more aggressive position for a longer duration, then you can shift your annual rebalancing amount to a smaller amount, say 2-3%. Then, if the Federal Reserve begins cutting rates (possibly signaling the latter innings of a bull market), go immediately to your target allocation. It’s worth noting that your target allocation will still benefit with something like 70% stocks, but you’re better positioned for a potential correction or crash and ideally able to hold on to more of your gains from a long bull market.
Using new contributions to rebalance
If you’re contributing enough money on an ongoing basis, you might be able to achieve some sort of rebalancing measure by investing new cash into the area that is underweight from your target allocation. Note that this is going to get harder and harder as the size of your portfolio grows, but for investors only a few years in, you might be able to achieve some sense of rebalancing with new money. This also prevents you from having to sell anything as you rebalance which can sometimes lead to taxable events.
On the flip side, if you’re in withdrawal mode during retirement, you can sell assets that are overweight your target allocation when raising cash in order to maintain a target allocation. Obviously, you need to be taking in plenty of tax advice during any sort of withdrawal mode.
Rebalancing is a simple concept built around the idea that you can manage your risk by shifting asset allocations at various time back toward your target allocation. But as you can see here, we’ve presented many variations of this simple concept. Our goal in presenting so many variations was to give you lots to work with. Note, however, that if you don’t get specific with your own plan, having a number of variations in the back of your head is likely to lead to some bad results. Get specific, write down your investment plan and review it regularly.