How often should I rebalance?

I was originally going to write this post on how to maximize returns through rebalancing.  My underlying assumption was that rebalancing helps your portfolio by “buying low and selling high,” and that I only needed to figure out the best rebalancing interval (monthly, yearly, etc.) that would maximize my returns. Through my research, however, I was able to have some sense knocked into me by a couple of enlightening articles, and one fantastic quote by a Vanguard research report “Best Practices for Portfolio Rebalancing”  July, 2010:

“It is important to recognize that the goal of portfolio rebalancing is to minimize risk (tracking error) relative to a target asset allocation, rather than to maximize returns.”

This was such a great reminder for me.  The whole point of rebalancing is to make sure your portfolio reflects the level of risk that you are comfortable with.  If at the outset, you say you want 60% stocks and 40% bonds, then even a slight 0.1% shift towards stocks means your portfolio has more risk than you want it to.  Rebalancing for any other reason than to minimize tracking error is a form of active trading, which by now, it should be pretty clear I am against.

Should I rebalance every day then? Theoretically, Yes.  In reality, No.  In reality, it usually costs money to make trades.  Even if it doesn’t (like if you have a Schwab account and only buy Schwab ETFs), making these trades takes time.  So the real question is how much tracking error are you willing to accept in your portfolio, and how much time are you willing to take to maintain it.

How often should I rebalance in reality?  The industry standard is to rebalance every year, and that is a perfectly good approach.  In the Vanguard report linked above, Vanguard has a slightly more nuanced approach that I think makes the most sense.  The report suggests that you monitor your portfolio semi-annually or annually, and only rebalance when an asset drifts more than 5% from its target percentage.  They go on to say that this approach “is likely to produce a reasonable balance between risk control and cost minimization for most investors. Annual rebalancing is likely to be preferred when taxes or substantial time/costs are involved.”

I would also suggest that you rebalance every time you add money to your account. Recently I’ve been putting money into a “house downpayment” account where I buy a number of index funds.  Since this is the type of account that I don’t make automatic deposits from my paycheck every month, I usually wait a few months and make a large contribution to portfolio and use the contribution to buy more shares of the 5 different ETFs that make up the portfolio.   Since I have to place orders anyway, I might as well make sure that my portfolio will reflect my preferred asset allocation after I finish the new trades.  This is an easy way to rebalance more than just once a year without requiring extra effort.

Does rebalancing help you get higher returns?  Ok, lets say you agree to the basic premise that rebalancing is only for the purpose of minimizing tracking error.  But does rebalancing actually get higher returns?  Is there is a rebalancing time interval (or threshold) that historically offers the best returns?  If so, then you would want to know, right?  The  answer  unfortunately depends on who you ask.

In the Vanguard study (mentioned twice and linked above), the summary states that, “Our findings indicate that there is no optimal frequency or threshold when selecting a rebalancing strategy. This paper demonstrates that the risk-adjusted returns are not meaningfully different whether a portfolio is rebalanced monthly, quarterly, or annually; however, the number of rebalancing events and resulting costs (taxes, time, and labor) increase significantly.”

Another financial advisor explains it in a different way.  The author says that when rebalancing, you are just as likely to “buy high and sell low” as it is the other way around.  He says that rebalancing can increase your returns – but only if you get the timing right.  In other words, you either have to be lucky, or trying your hand at market timing, which from my perspective is a losing proposition.  Two great posts explaining this can be found here and here.

Other researchers have tried to empirically prove that a certain method of rebalancing can increase returns, like this study by a Managing Director at TD Ameritrade. This study shows that there are “significant advantages of opportunistic rebalancing (look frequently and rebalance only when you need to) over traditional annual or quarterly rebalancing.”  In this approach, there is a complex method to determine whether you should initiate a rebalancing.  The approach outlined in the study is time consuming (it requires frequent portfolio checking) and borders on being an active trading strategy, but at least makes for an interesting read.

These three different takes are by no means an exhaustive inventory of all the views on rebalancing, but I think they are representative of the types of research you will find.  While you might find a complex method of rebalancing that can add a few basis points on your annual return, don’t forget that the point of rebalancing is simply to reduce your risk.

Advertisement

6. Portfolio Rebalancing

This is part six of seven in my attempt to explain how you should invest in your retirement portfolio.  Click here for part five.

In a nutshell, portfolio rebalancing is when you check up on your portfolio at certain intervals of time and make sure that the percentage of each asset class in your portfolio remains close to the percentage that you originally set for it (as discussed in part 3).   Here is a quick illustration: Lets say I bought $1,000 each of two funds for my portfolio – a stock fund and a bond fund – and I want each fund to make up 50% of my portfolio at all times.  After 1 year, my stock fund went up 20% and my bond fund declined 5%.  As a result I had $1,200 in my stock fund and $950 in my bond fund.  My total portfolio value gained a little to become $2,150, but now had 55.8% (1,200/2,150) of my portfolio in stocks and 44.2% in bonds.  Because it is important for me to maintain a 50/50 split in my portfolio to reduce risk I would sell shares of my stock fund and buy shares of my bond fund so that each fund would have half of my new portfolio value which was $1,075 (2,150/2).  This is called portfolio rebalancing.

I’ll admit its not a very sexy topic, but it is one of my favorite parts about retirement investing because it takes the human element out of your decisions.  The beauty of rebalancing is that you never try to time the market, and you never have to guess about where its going.  If you choose to rebalance every year (a good strategy), then you can buy funds in january and not worry about a thing until december comes along.  Then in january you don’t even have to “research” the market, you just buy or sell funds to make sure that all the assets in your portfolio make up their proper percentage.  Why do I love taking the human element out of the equation?  Based on my own experience and plenty of data, we only get in our own way when we try and “time the market.”

Are humans really that bad at market timing? Dalbar Inc. is a Boston based research firm that publishes an annual report called the QAIB or Quantitative Analysis of Investor Behavior.  They charge $99 to see the annual report, so I haven’t seen it with my own eyes, but I did read a book called It’s Not about the Money by Brent Kessel which described a recent QAIB report.   According to the book, the report studied the actual returns of all investors in equity mutual funds from 1987 to 2006.   The report showed that the average investor would add money to their investment account when the market went up, and then take out money when the market went down.   As a result of this behavior, the typical investor grew $10,000 into $23,252 in 22 years.  Over the same time period, the S&P 500 grew $10,000 into $93,050.

In this example we are talking about people who are simply investing in mutual funds – NOT investing in individual stocks.   As I have explained above, mutual funds are essentially index funds, except they have a 1-2% smaller return.  So what this study is really saying is that the reduction in gains is not a result of picking the wrong stocks, but simply buying and selling at the wrong time.  Its just human nature to want to trade too much and  to go after the “hot fund.”  Its almost like we can’t help ourselves from selling low and buying high – and that is why portfolio rebalancing at set intervals is so successful.  You won’t worry about getting in your own way.

Investor opinions during the recent market slump in 2009 and subsequent recovery also provide an excellent example of how challenged humans are in making the correct investment decisions.   According to a Gallup poll from March 4th 2009 –  just a few days before the market bottom  – only 18 percent guessed that the stock market would recover by year end.  As it turns out, the S&P 500 gained 67 percent from its low point on March 9th until the end of the year meaning just 18% of Americans guessed right.  The poll results from the above link are posted below:

How often should I rebalance my portfolio?  I was so in love with the idea of portfolio balancing that I was ready to rebalance my portfolio once a month.  I wasn’t sure how I was going to make the numbers work – because as explained in part 5, the commissions associated with making 10 trades a month were pretty high.  As it turns out, there really is no right answer – there are studies that show monthly rebalancing to be the most effective, and other studies that show annual rebalancing to be most effective.  Still other studies suggest that its not the time period that should trigger your rebalancing but whether your original asset allocation is broken by a certain percent (like 10%).  Regardless of time period or other method you choose to trigger your rebalancing, the important thing is to come up with some way to adjust your portfolio that will take any emotion or attempt to time the market out of the equation.

Based on my research it seems like rebalancing your portfolio annually is a safe approach.  But just because you rebalance annually, it doesn’t mean you should be putting money into your retirement portfolio only once a year.   As I explained at the end of Part 5, once a year investing reduces your return because your money wasn’t in the market getting 8% a year, and is risky because you are not paying yourself first.  So in the end, even after taking into account annual rebalancing, it is still important to put money into retirement once a month – which means there is really no way to avoid paying large amounts of money just in trade commissions.  With this realization I decided to revisit target date funds.

To continue reading, follow the link to Part 7 – The Solution.