DR 051: Rebalancing–How to Create a Plan to Easily Rebalance Your Investments

Rebalancing InvestmentsRebalancing your investment portfolio is an important part of managing your money. Having carefully selected your asset allocation, rebalancing ensures that your investments stay in line with the allocation you’ve chosen.

In this article (and podcast) we cover creating a rebalancing plan. We’ll cover topics such as how often to rebalance (frequency) and what to rebalance (threshold). In the podcast to follow, I’ll walk through the specific steps you can take to actually rebalance your portfolio.

Asset Allocation Recap

If you’re up to speed on asset allocation, you know that it’s all about deciding how much you want in stocks, bonds, and cash. These asset classes can be further sub-divided. Stocks can include U.S and foreign stocks, small cap stocks, emerging markets, and so on.

Bonds may include U.S. and foreign bonds, government and corporate bonds, as well as munis and TIPS. There are also alternative asset classes, such as REITs (Real Estate Investment Trusts) and commodities.

When you’re investing, you decide ahead of time – before you even pick your mutual funds – what you want your asset allocation to look like. There’s no one-size-fits all answer to this question. You need to do your research, and then decide what’s right for you.

For today, let’s assume that you’ve chosen to invest 70% of your retirement money in stock mutual funds and 30% in bonds. So you start out with that exact allocation. But as the prices of stocks and bonds move up and down with the market, your portfolio will drift away from that original allocation.

You may find a few months or a year down the road when you look at your accounts, that you no longer have 70% in stocks. Maybe now you have 75% in stocks, which means that you now only have 25% in bonds. Rebalancing is nothing more than correcting this imbalance by returning your portfolio to its original 70/30 allocation.

This raises three questions, the first two we’ll cover today:

  1. How often should you rebalance your investments?
  2. How far from your asset allocation plan should you allow you investments to drift before rebalancing?
  3. When it’s time to rebalance, how do you actually do it? (That’s in the next podcast.)
  4. Approaches to rebalancing

    There are three main rebalancing strategies.

    Frequency

    The first is based on frequency. You simply decide that you’ll balance your portfolio every month, every three months, once a year – however often makes sense for you. Large pensions sometimes rebalance daily. For most individual investors who go this route, rebalance once or twice a year is sufficient. With this approach, you rebalance regardless of how much your asset classes have drifted from your target asset allocation plan.

    Threshold

    The second approach is based on threshold. In other words, there’s no particular time involved. It’s simply that you’ll rebalance when your various asset classes drift by a certain amount. For instance, using our 70% stocks/30% bonds portfolio, you may set a threshold of 5%. So you’ll rebalance when either asset class gets more than 5% away from its original starting point.

    If stocks rise to 75% of your portfolio or bonds rise to 35%, you’d rebalance. The downside to this approach is that you have to check your asset allocation frequently to know when you’ve crossed the threshold. You may not have to check it daily, but you’ll need to check weekly or monthly if there are lots of ups and downs in the market. You’ll also have to check your portfolio more frequently if you set a lower threshold.

    Frequency & Threshold

    The third approach is the one I use. This combines both frequency and threshold. You decide that you’ll check every month, quarter, year, or whatever. But you only rebalance your portfolio if it passes a certain threshold when you do check it.

    In my case, I look at my portfolio monthly, which is probably excessive. But since I enjoy it and blog about it, that’s a habit I’ve fallen into. But I don’t rebalance until my portfolio reaches the 5% threshold. So if my stock allocation is 80% and my bonds are 20%, I’d have to see stocks go above 85% or below 75% before I’d rebalance.

    What’s best for you?

    There’s no one right answer as to which rebalancing approach you should use. But you should take some things into consideration as you’re deciding what plan is best for you.

    First, you need a rebalancing plan. Whether you take the frequency approach, the threshold approach, or the combination approach, you need to know ahead of time when you’ll rebalance. A plan is important because without one, you’ll be tempted to let the market dictate your rebalancing strategy..

    For example, the S&P 500 Index was up more than 32% in 2013. Without a plan, many investors would be unlikely to move investments from stocks to bonds during such a bull run, even if their stock allocation was significantly overweighted. Similarly, when the stock market is down 30%, it can be very hard to move assets from bonds to stocks. Following a plan helps you do the right thing.

    Second, consider cost. It may cost you money to rebalance, which we’ll talk about in the next podcast and article. So as you think about what approach you want to use for rebalancing, think about costs.

    For instance, if you trade investments in a taxable account to balance your portfolio, that could trigger significant taxes. Also, you’ll have to pay fees, sometimes, when you rebalance. Typically in a 401(k), there won’t be any fees to buy and sell mutual funds. (But you need to confirm that with your plan administrator.) With IRAs and taxable accounts, there could be fees, depending on where you have your accounts and whether you’re investing in individual stocks or ETFs.

    Finally, there’s a time aspect to all of this. You may have a 401(k), and your spouse may have a 401(k), and you could have multiple IRAs and taxable accounts. It’s a real headache to rebalance, and that’s worth considering. A more simple strategy is often best.

    For all these reasons, I think that rebalancing once or twice a year is probably enough for most people – with or without a threshold. You have to decide what’s right for you, but it’s worth thinking about the money, time, and energy involved in this process.

    Rebalancing annually or semi-annually is usually fine

    The Vanguard white paper, “Best Practices for Portfolio Rebalancing,” evaluates going back to 1929. What the authors conclude is that, for most investors, it’s perfectly fine to rebalance either annually or semi-annually with a threshold of about 5%.

    In other words, once or twice a year you’ll look at your investments, and if they’ve moved away from your asset allocation plan by more than 5%, you’ll rebalance. What Vanguard found is that you could do this monthly or quarterly, but when looking at data over long periods of time, it doesn’t significantly decrease the risk in your portfolio. And even if you want to focus on returns, instead of risk, rebalancing monthly versus quarterly or annually won’t have a significant difference in returns.

    So for most people, this frequency and threshold option is a good approach. Check your portfolio once or twice a year, and if you get out of whack by more than 5%, rebalance.

    Now I should add this: if you have a more complicated asset allocation plan, this may be a bit different. For instance, if you have 10% in REITs, it’s unlikely that they’re going to fall to 5% or rise to 15%. So what I’d do in that case is to look at a change of 25% of that 10%. In other words, in case of an asset class where I’ve allocated 10% of my investments, I’ll look for that asset class to move one way or another by 2.5% (25% * 10%). So if it goes down or comes up by 2.5%, I’d rebalance.

Published or Updated: April 9, 2014
About Rob Berger

Rob founded the Dough Roller in 2007. A litigation attorney in the securities industry, he lives in Northern Virginia with his wife, their two teenagers, and the family mascot, a shih tzu named Sophie.

Comments

  1. Kenneth says:

    There are two automatic options (doubtless lots more) that I know of for automatic rebalancing:

    1. Betterment – just dial in the meter to indicate percent stocks, percent bonds. As dividends are received, Betterment spreads them in a fashion to keep you balanced. If more balancing is required, I think once a year they will swap out stocks for bonds or vice versa to get your portfolio tuned up. So they create as little capital gains as possible on a taxable portfolio.

    2. Vanguard – they have some wonderful target dated funds which are rebalanced from time to time to bring it in line with your target date to retirement. Ages 27-31 receive a 90/10 stocks/bonds split, those selecting the target date 2015 fund are treated to a 53/47 stocks/bonds split.

    • Rob Berger says:

      Both are great options.

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