- Allocate new funds in a planned manner. For example, if one stock in your portfolio has become overweighted, put your fresh deposits into other stocks you like until your portfolio is back in balance.
Because rebalancing the “conventional” manner without investing any more money requires you to sell your best-performing assets, you may choose the second option. We like the second method since it allows you to rebalance by adding new funds while leaving current winners alone to (hopefully) continue to outperform.
It’s worth noting that your portfolio may rebalance automatically if you invest through a robo-advisory service or an employer-sponsored retirement plan like a 401(k).
Is it necessary to rebalance my ETF?
Example of the S&P 500 The majority of large stock market index funds and exchange-traded funds (ETFs) do not rebalance. They are weighted according to the market. Most S&P 500 index funds and ETFs, for example, do not rebalance, such as the State Street SPDR S&P 500 (SPY) SPY +0.1 percent.
In an ETF, how does rebalancing work?
The portfolio is rebalanced to a 50:50 distribution. This suggests that 66 shares of the stock ETF should be sold and 74 shares of the bond ETF should be purchased in the sample portfolio.
How often should my ETF portfolio be rebalanced?
Portfolios can be rebalanced at predetermined intervals (quarterly, monthly, or annually), as well as at predetermined allocation points (when the assets change a certain amount). Because markets vary more in some time periods than others, rebalancing by specified asset targets is a useful way to approach portfolio rebalancing. When an asset allocation changes by more than 5% for example, if a certain subset of equities moves from 15% to 20% of the portfolio it’s time to rebalance.
Multiple studies have linked the frequency with which an investor monitors his or her portfolio to market losses over timebecause the more frequently an investor checks it, the more stressed they are over little ups and downs, and therefore the more likely they are to withdraw money when they shouldn’t.
Another strategy to figure out when to rebalance your portfolio is to schedule it at regular intervals, such as every quarter or at the beginning of the year. According to a Vanguard analysis, there was no discernible difference in risk-adjusted returns whether the portfolio was rebalanced monthly, quarterly, or annuallyespecially when transaction fees are factored in.
When an asset allocation changes by more than 5%, it’s a good idea to rebalance.
For many people, the end of the year is a good time to review their financial investments and consider any prospective changes in the future year.
The disadvantage of rebalancing at certain times is that you risk overdoing it. Just because it’s on your calendar doesn’t imply you have to rebalance if your asset allocation hasn’t strayed too far from your target.
Rebalancing a portfolio depends on how involved you want to be and what stage of life you’re infor example, people approaching retirement may wish to rebalance more frequently as a risk management strategy.
Why should you avoid rebalancing your portfolio?
- Although it is common knowledge that we should rebalance our investment portfolio on a regular basis, this may not always be the case.
- Rebalancing is selling certain assets and purchasing others in order to align your portfolio with a stated aim and target asset allocation.
- When you rebalance, you may be selling a high-performing asset to purchase more of a low-performing one.
- When it comes to broker commissions and the tax burden on the earned income that will be realized, rebalancing can be costly.
Is it a good idea to rebalance?
At any age, rebalancing is a smart idea. It lowers risk by avoiding excessive stock exposure and instills healthy habits by instilling the discipline to stick to a long-term financial strategy. According to Christine Benz, director of personal finance at Morningstar Inc., “the usefulness of rebalancing shoots up after retirement.”
Is it possible to rebalance without selling?
Working with a robo-advisor takes very little time and effort on your part: All of the work is done automatically by the robo-advisor. All you have to do is open an account, deposit funds, and either specify your goal asset allocation or answer the software’s questions to assist it in determining one for you.
Costs are also low. Betterment, Wealthfront, and SigFig, for example, adopt ways to reduce the cost of rebalancing by avoiding or lowering short- and long-term capital gains taxes. When rebalancing your portfolio, one popular method is to avoid selling any stocks. Instead, the robo-advisor utilizes the money you deposit or receive as a dividend to buy more of the investment you’re underweight in.
If your portfolio has shifted from 60 percent stocks to 40 percent bonds to 65 percent stocks to 35 percent bonds, the robo-advisor will utilize your deposit to buy more bonds the next time you deposit money. You avoid any tax repercussions by not selling any investments. Cash flow rebalancing is the term for this method.
You can use this approach to save money on your own as well, but it only works in taxable accounts, not retirement accounts like IRAs and 401(k)s. When you buy or sell investments within a retirement account, there are no tax ramifications.
Another way robo-advisors keep transaction costs down is to sell whatever asset class you’re overweight in whenever you take money out of your account.
Furthermore, when your robo-advisor rebalances your portfolio, you won’t have to pay commissions, transactions, or trading fees like you would if you did it yourself or with the help of an investing advisor. These fees are not charged by robo-advisors. Instead, they charge an annual fee based on the value of the assets they manage on your behalf.
Betterment, for example, charges a 0.25 percent yearly fee on assets under management and has no minimum account balance requirement. Because robo-advisors are computer-assisted, they may rebalance your portfolio as frequently as daily, ensuring that it is always in close to perfect balance.
How does index rebalancing work?
The process of realigning the weightings of a portfolio of assets is known as rebalancing. Rebalancing is buying and selling assets in a portfolio on a regular basis in order to preserve an initial or intended level of asset allocation or risk.
Let’s imagine your initial asset allocation goal was 50 percent stocks and 50 percent bonds. If the stocks had fared well over the period, the portfolio’s equity weighting could have been boosted to 70%. To return the portfolio to its initial goal allocation of 50/50, the investor may elect to sell some stocks and acquire bonds.
What is the frequency of rebalancing?
After taking into account taxes and transaction costs, we attempt to interpret what we perceive to be the ideal rebalancing frequency. We’ll explain why we think investors would be better suited establishing a controlled rebalancing frequency in this research. When considering return, risk, and rebalancing costs for investors with taxable assets and a medium to long-term investment horizon, we find that a rebalancing strategy that uses a 5% rebalance trigger (basically rebalancing a portfolio whenever an allocation deviates 5% from its target weight) is the most optimal.
Costs of Rebalancing
The observable, tangible expenses of rebalancing include transaction fees and realized taxable profits. Transaction costs exist whether an investor pays transaction commissions or pays for services on a fee basis. Additionally, the bid/ask spread that must be paid when selling and purchasing assets in order to rebalance affects all clients. While the bid/ask spread is normally modest (as low as $0.01 per share), when rebalancing an entire portfolio, this expense can mount up quickly. After-tax returns are just as significant, if not more important, than pre-tax returns for clients with taxable investments. As a result, minimizing unnecessary capital gains recognition is critical to maximize after-tax earnings. Due to the nature of rebalancing, assets that have appreciated the greatest in comparison to others in the portfolio are sold in order to increase the allocation to assets that have not performed as well in absolute terms. This leads to a natural desire to sell gains, so raising your tax liability.
When deciding on a rebalancing frequency, taxes and transaction expenses must all be taken into account. Taxes may not apply to all investors or all components of a portfolio. Investors with tax-deferred annuities, IRAs, or 401(k) plans, for example, will not have to consider tax considerations when deciding on a rebalancing discipline. When deciding on a rebalancing frequency, transaction costs will always be taken into account.
Methods of Rebalancing
Individual and institutional investors use five different types of rebalancing:
When using the first strategy, which involves no rebalancing, an investor is effectively allowing their portfolio to drift and allowing the market to rebalance it for them. As large-company stocks rise in value and bonds fall in value, bond allocations will decrease and large-company stock allocations will increase.
Rebalancing on demand does not impose a strict rebalancing schedule; rather, it allows investors to make tactical decisions about when they believe it is time to rebalance their portfolio. The stock market, for example, reclaimed its positive stance in 2003, with large-company stocks climbing 28.7%1 and small-company stocks rising 47.3 percent2. After such a year, it’s understandable that some of these earnings would be taken off the table and reallocated to bonds. With rising interest rates expected in 2004 and a bad outlook for bonds, an investor rebalancing on demand may have made the tactical decision to wait until rates rose before rebalancing to bonds.
The most prevalent and disciplined technique of rebalancing is frequency rebalancing.
To rebalance, an investor selects a recurrence rate, such as quarterly, semiannually, or annually. A portfolio is rebalanced on a predetermined frequency, regardless of market direction or market expectations.
Allocation triggers define asset allocation boundaries, causing a portfolio to be rebalanced if a border is crossed. A 5% trigger put on a 50/50 stock/bond allocation, for example, would rebalance the portfolio anytime one asset class reached 55 percent or 45 percent of the total. This strategy allows portfolios to change with the market and does not rebalance unless there has been a big move, albeit it is less disciplined than a defined rebalancing frequency.
Finally, the hybrid method combines a rebalance frequency and a trigger for allocation.
Setting an annual rebalancing frequency with a 5% trigger and declaring that the portfolio will be rebalanced at least once a year is an example. However, if the portfolio deviates from its objective by 5% during the year, it will be rebalanced at that time as well.
These strategies, taken together, give investors flexibility in deciding how much they want to let market fluctuations rebalance their portfolios. Furthermore, investors have the opportunity to choose the level of discipline they want to infuse in their investment policy based on their comfort level with the markets. The transaction costs and taxable consequences of rebalancing will be lower if the number of events to rebalance the portfolio is kept to a minimum.
Optimal Rebalancing Frequency
At the individual level, investors should determine a rebalancing frequency that is best for them in order to reduce risk and maximize return while minimizing costs (transaction costs and taxes).
There isn’t a lot of research on how to choose the best rebalancing frequency. The idea that it doesn’t matter what approach you use to rebalance is an incredibly consistent message throughout the research that has been undertaken.
To put these theories to the test, we conducted our own research on two scenarios to identify the best rebalancing method and frequency. We compared (back-tested) a number of rebalancing approaches against historical investment returns to arrive at our conclusions. We started this analysis by looking at a simple portfolio of 60% equities and 40% bonds. For this simple comparison, the following approaches were considered: no rebalancing, annual rebalancing, quarterly rebalancing, and rebalancing based on a 5% trigger. We also did a second analysis using a more diverse portfolio that comprised major, small, and overseas equities, as well as bonds. We included two more rebalancing options in this scenario: a 10% trigger and a hybrid 5% trigger with automatic annual rebalancing.
When analyzing the effects of rebalancing a 60% stock/ 40% bond allocation3 from 1979 to 2003 (Figure 1), it was clear that rebalancing alone reduced volatility by approximately 18%, lowering the long-term standard deviation from 12.2 percent to 10.3 percent. The difference in volatility (as assessed by standard deviation) between the three rebalancing frequencies (annual, quarterly, and a 5% trigger) was modest, indicating that it is the decision to rebalance that makes a difference, not the technique of rebalancing. When the returns of different approaches were compared, it was found that not rebalancing the portfolio produced a somewhat better return than the other rebalancing methods.
*Sharpe ratio derived using a straightforward Sharpe formula (Return/Standard Deviation).
We utilize a simplified version of the Sharpe Ratio to analyze return and risk together. This ratio is calculated by dividing the portfolio’s return by its risk (standard deviation). In the annual rebalancing technique, for example, the return (12.39%) is divided by the standard deviation (10.30%) to yield a Sharpe Ratio of 1.20. This can be translated to mean that for every unit of risk (standard deviation), an investor earns an extra 1.20 percent.
An investor is better off rebalancing based on these results on a risk-adjusted basis (i.e., Sharpe Ratio). The Sharpe Ratio produced by all three rebalancing frequencies was 16.5 percent greater than the Sharpe Ratio obtained without rebalancing. When transaction costs and taxes are taken into account, an investor would be better off choosing the 5% rebalance trigger because it produces the fewest rebalancing events. A 5% rebalance trigger would have resulted in 17 fewer rebalancing events over the 25-year period studied, compared to 100 events with quarterly rebalancing.
While the pure returns for not rebalancing the portfolio are slightly better than the other options, there is a significant difference in volatility between the rebalanced and non-rebalanced portfolios. The decrease in standard deviation is largely due to lower volatility in down markets. Rebalancing back to bonds after stocks have run creates a better cushion in a sinking stock market, resulting in decreased volatility. Above is a list of calendar year performance from 1995 to 2003. (Figure 2).
We took this study a step further in our second scenario, comparing the performance of a diversified mix of bonds, large firms, smaller companies, overseas stocks, and cash. This was a modest Growth and Income allocation consisting of 40% fixed income, 40% major firms, 7% small companies, and 13% international stocks. 4 This study covered the time span from January 1988 to December 2003. We compared three rebalancing techniques in this study: quarterly, a 5% trigger, a 10% trigger, and a 5% trigger with an automatic annual rebalancing.
The findings of this analysis are shown in Figure 3 on the following page, with the same conclusions as our previous comparison. The frequency of rebalancing has little impact on overall returns, but the decision to use a rebalancing discipline reduces overall volatility in an investor’s portfolio significantly. More crucially, the decrease in volatility is due to a 29 percent increase in consistency in down markets. Although the risk-adjusted returns, as assessed by the Sharpe Ratio, demonstrate that all rebalancing techniques are similar, we believe that using a 5% trigger is the most optimal. Due to the small number of rebalancing events each day, a compelling case might be made in favor of a 5% or 10% rebalancing trigger after considering transaction costs and taxes. We advocate a 5% trigger to help limit risk within the portfolio, as it will prevent the portfolio from taking on an overly aggressive or conservative posture.
We also examined the results’ sensitivity to modifications in the initial allocation. The results did not change as the asset allocation was changed to be more cautious or aggressive.
The findings of this study are consistent with other industry studies, indicating that the method and frequency of rebalancing are unimportant as long as an investor maintains a rebalancing discipline. Rebalancing, contrary to popular opinion, does not appear to improve investment returns. However, it has been shown to lower volatility greatly. In low markets, this decrease in volatility has tended to occur.
After accounting for taxes and transaction costs, we feel a 5% trigger is the best rebalancing discipline. According to our research, this strategy outperforms other ways, and the lower number of rebalancing instances (as compared to a quarterly or annual rebalancing method) would result in lower transaction costs and taxes. When it comes to taxes, a quarterly or annual rebalancing technique is more likely to recognize short-term profits, which are more expensive to tax than a 5% rebalancing trigger, which is less likely to identify short-term gains. The disadvantage of a 5% rebalancing frequency is that it is not as static or automated, and it requires the investor and their financial advisor to evaluate their asset allocation more frequently to ensure that a trigger has not been broken.
While we have an opinion on the best rebalancing frequency, it’s vital to keep in mind that each investor is unique. Regardless of our viewpoints, the most important thing is that investors rebalance, with the manner of rebalancing being a secondary consideration.
3I used the S&P 500 as an equities proxy and the Lehman Aggregate Bond index as a bond proxy.
4
The performance of large-company stocks was simulated using data from the Russell 1000 index. The Russell 2000 index was used to imitate small-company stock outcomes, while the MSCI EAFE index was used to model overseas stock results. As a proxy for bond performance, the Lehman Aggregate Bond index was employed.
5Assuming volatility fell from 4.65 percent without rebalancing to 3.30 percent on average after rebalancing. This 1.35 percent drop accounts for a 29% reduction in volatility as measured by standard deviation.
Cindy Sin-Yi Tsai, “Rebalancing Diversified Portfolios of Various Risk Profiles,” 6Sin-Yi Tsai, “Rebalancing Diversified Portfolios of Various Risk Profiles,” 6Sin-Yi Tsai October 2001, Journal of Financial Planning.
Transaction costs and taxes are not included in the returns calculated in this research. These charges are unique to each client’s financial condition and cannot be predicted properly. Transaction expenses might be in the form of an up-front charge, a back-end charge, a quarterly fee, or a per transaction charge. Individual tax rates vary depending on the federal, state, and local tax rates. Transaction fees and taxes would reduce the returns represented in this research, so investors should be aware of that.
When should my portfolio be rebalanced?
The frequency with which you rebalance your portfolio is totally up to you. It could be done on a monthly, quarterly, biennial, or annual basis. The benefit of employing a time-based strategy is that it’s easy to form the habit of rebalancing, ensuring that you don’t forget. While you’re rebalancing, you can look over the cost ratios of the mutual funds or exchange-traded funds you own, as well as the commissions you’re paying to your brokerage.
You can also decide to rebalance your asset allocation when it reaches a certain point. Assume you want to allocate 80 percent of your portfolio to equities and 20 percent to bonds. You can make a rule for yourself to rebalance your portfolio whenever the stock part of your portfolio reaches 85%. This is a common rule of thumb to follow, though you can use a different proportion if you want. If your asset allocation changes by 10% or 15%, for example, you may elect to rebalance.
The benefit of rebalancing in this manner is that it prevents your portfolio allocation from being out of whack for long periods of time. If you simply rebalance once a year, for example, you could end up with an asset allocation that doesn’t match your goals or risk tolerance for the most of the year.
The key to either method is to stay away from going overboard. Assume you have a quarterly rebalancing schedule. If your asset allocation hasn’t altered significantly, rebalancing merely because it’s time to rebalance could be unproductive. Rebalancing after your asset allocation exceeds a certain percentage range, on the other hand, could be difficult if it implies paying higher brokerage costs.
While many brokerages have implemented no-commission trades for U.S. equities and ETFs, fees for mutual funds and bonds may still apply. So, while rebalancing may help you keep your portfolio in check, it may also result in increased expenses.