How are you rebalancing your investment portfolio?
How many of you garden? For those who know me, I’m actually knee high in weeds right now, in our new lavender farm. After converting a few acre pasture, we decided it would be fun and even possibly profitable to grow lavender that supposedly does so well in our climate. But, despite the laborious process, the weeding must be done.
Similarly, each of us needs to go through the laborious process of “weeding” our portfolios regularly each year. You may feel, like me and my lavender, that you are so in the “weeds” during this particular economic cycle and rebalancing may not even be on your radar of things to do, but it still behooves you to rebalance regularly. After all, that is one important aspect of a disciplined, investment process.
Asset Allocation Strategies: Rebalance Your Portfolio
Keeping your portfolio in line requires rebalancing your portfolio. Otherwise, your risk/reward profile tips to a place where you barely recognize it -– like my field drowning in weeds. A 50 stock/50 bond portfolio can quickly become 65/35 or 35/65 unless we keep an eye on it and rebalance. For instance, suppose you’re investing in gold and have some cash investments and bond products in your portfolio. Maybe some stocks and equity funds. You’ve diversified well. But because these asset classes rise and fall in value each year, their representation in your portfolio will change with time. Hence, you’ll want to get those proportions back to their original numbers. You achieve this by rebalancing. But unfortunately, many people fail to do this.
Perhaps there has been enough written and said of this topic, but people just don’t seem to get around to doing it on their own. I think the majority of people struggle because the task seems daunting and there is no clear blue print of how and when to rebalance. So to help, here are three common approaches from which you can pick.
#1 Time-Only Portfolio Rebalancing Strategy
When using this strategy, the portfolio is rebalanced every day, month, quarter, or year, without care for the degree of drift seen in the asset allocation. The only matter of concern here is the time element.
The question, of course, then turns to: How frequently should you do this? The answer depends primarily on your preference — the amount of drift you have experienced from your original allocation that you are comfortable with, in addition to the costs and possible capital gains you are willing to incur. The good news though, is that research suggests that the rebalancing frequency doesn’t really factor into your portfolio’s performance that much. But interestingly, there are differences in performance between those portfolios that are rebalanced and those that aren’t. So it actually matters that you actually make the effort to rebalance. On this note, I personally prefer the quarterly rebalancing approach. Daily and monthly moves seem too soon, while doing this once a year seems way too long. Either way, the fact remains true: you need to rebalance.
#2 Threshold-Only Portfolio Rebalancing Strategy
The second strategy takes away the time element when rebalancing. Investors following the “threshold-only” approach instead rebalance the portfolio when the asset allocation has shifted by some minimum amount. That amount can be a certain designated percentage (you can decide that a shift of 5% or more can trigger your need to rebalance, for instance). You’d rebalance as often as there is a drift or shift. The primary drawback to the threshold-only strategy is that it requires almost daily monitoring and has the chance of increasing trading activity (depending on the threshold size), thereby increasing costs and taxable events. Again, I like to use a threshold that is in the middle, say a minimum of around 5%, since your portfolio’s risk/reward profile will not change too much for percentages below that.
#3 Combining Time-and-Threshold Factors When Rebalancing
The final strategy, which I personally prefer over the other two, calls for rebalancing the portfolio on a scheduled basis (e.g., monthly, quarterly, or annually), but only if the portfolio’s allocation moves away from its target allocation by a minimum threshold (of a given percentage). So to make this work, you’d only review your portfolio at scheduled times, and you’d only rebalance if you saw your portfolio drift by the designated minimum of 5% or 10% from the target allocation (for instance). If, as of the rebalancing date, the portfolio’s deviation from the target asset allocation is less than the predetermined threshold, the portfolio will not be rebalanced. So, this third option combines the first two.
Smart Ways to Rebalance
Instead of going through the arduous task of figuring out the rebalancing calculations and trades, you may consider rebalancing your portfolio income (dividends, interest, etc.) or new contributions. You could accomplish this by redirecting these flows to the most underweighted asset class(es) as part of their scheduled rebalancing event. This is one way to avoid the extra costs, time, and potential tax consequences of buying and selling to rebalance.
But, not everyone has adequate cash flow/contributions!
Should this be the case, then you need to make the decision to rebalance either to the ideal target asset allocation or to some other allocation that is close. Again, due to costs and taxes, you may want to only get close to your target allocation. Another strategy could be to rebalance close to your target asset allocation this year and the rest next year to spread tax liabilities into two tax years. So it would depend on the circumstances.
Just as there is no universally “best” asset allocation or portfolio, there is no universally optimal rebalancing strategy. Sorry, no one size fits all in the investment world! The clear advantage or rebalancing, regardless of your method, is that a rebalanced portfolio remains aligned with the characteristics (risk, returns, volatility, etc.) of your own personal optimal asset allocation. And personally, I think that is more important than figuring out the direction of the economy or what the top mutual fund is for 2010/2011.
Ultimately, you may finally decide that it’s worth it to hire someone else to clear the weeds. Perhaps you can apply your time to more enjoyable pursuits. If you do, just make sure your hired professional has a disciplined and consistent rebalancing process (similar to the ones mentioned above) and you feel comfortable with their approach. Make sure that what they do makes sense for your particular situation.
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{ 8 comments… read them below or add one }
Right now I am getting more bullish on the market, so more of my portfolio is moving into commodity and energy stocks.
I do think it is important to rebalance. As you get nearer to retirement, you probably need to be phasing into less risky investments. This means less in stocks or stock funds and more in other areas.
Also, looking for fixed income investments is always important.
I think rebalancing is a bad idea. Investors should be aiming to stay at roughly the same risk level at all times. Stocks are far more risky when valuations are high than they are when valuations are moderate or low. So investors need to be sure to lower their stock allocations when stock valuations rise.
Rob
Learning about this for the first time and looks like re balancing won’t be a bad idea especially as you get closer to retirement.
My take is that the ideal approach (for me, anyway) is to rebalance based on a fixed period of time – say, quarterly. That said, I need to make more of a commitment to follow this.
At this point, I would rather take an active role than focus on target date funds, though admittedly it’s a cost/benefit analysis that I haven’t put time into. This does pique my interest though, and you may have influenced me to take another look to give this further consideration.
I am currently setting up a spreadsheet to help me manage my investment portfolio so I can determine where, when, and how I want to rebalance my portfolio. It is an interesting project but utilizes the hybrid approach you mentioned here, time and threshold.
How’s the weed-pulling going?
My upcoming Video e-Course will include a re-balancing worksheet to make the time-and-threshold re-balancing strategy very easy to implement. I think that’s the best rebalancing option for most individual investors.
Here is some interesting dialogue about rebalancing triggers. What is yours?