How to Effectively Rebalance Your Investment Portfolio

Fajasy
Updated: March 21, 2024

Contents

In this article, I will explain how to effectively rebalance your investment portfolio. Portfolio rebalancing involves realigning the proportions of various assets in your portfolio to restore the weight of each asset class to its original target. This is important, because merely setting up a portfolio and then neglecting it can lead to a significantly different risk and return profile over time due to the varying performance of assets. Thus, employing the appropriate rebalancing strategy can help you manage your portfolio's risk and potentially enhance your returns.

This article will cover the concept of portfolio rebalancing, its importance, the various approaches investors can take to rebalance their portfolio, and the different timing strategies for portfolio rebalancing. Multiple examples and studies will also be provided to illustrate the effectiveness of various rebalancing techniques and their impact on a portfolio's performance.

Portfolio Rebalancing Explained

When you begin your investing journey, establishing clear objectives and selecting an asset allocation strategy that suits your risk tolerance and return goals is essential. If your investment strategy does not involve a diverse mix of asset classes and instead focuses on a single type of investment, portfolio rebalancing may not be as relevant or necessary, since the concept primarily applies to diversified portfolios aiming to maintain a specific risk and return balance over time.

Proper diversification can be achieved by spreading investments across:

  • Types of Assets: Equities, fixed income (bonds), commodities, and cash reserves.
  • Market Capitalization: Stocks from large, medium, and small companies.
  • Geographical Spread: Investments in domestic companies, and international emerging and developed markets.
  • Sector Allocation: Positions in various sectors like technology, health care, utilities, consumer goods, energy, etc.
  • Investment Approach: Holdings in exchange traded funds (ETFs) and/or mutual funds focusing on growth opportunities, value investments, or dividend-yielding stocks.

For instance, a long-term balanced investment strategy might target a 60% allocation in stocks and 40% in bonds (60/40), with stocks divided among different sectors, company sizes, and regions, and bonds split between government and corporate bonds.

Over time, due to different performance rates among these diversified assets, your portfolio's actual allocation may shift away from its original target. For example, if your stocks outperform your bonds (as expected), your portfolio might lean more heavily towards stocks than intended, say a shift to a 70% stocks and 30% bonds allocation (70/30).

Portfolio rebalancing is the strategy employed to correct such drifts by selling off investments from overrepresented categories and buying more from underrepresented ones to return to the original asset allocation, in this case, back to the 60/40 split between stocks and bonds. This adjustment helps maintain your desired level of risk and can potentially enhance returns by systematically selling high and buying low, as detailed later.

It's important to note that a shift in your portfolio's allocation doesn't necessarily require any asset to lose value. Differences in the rate of return among your diversified investments will naturally cause some to become a larger or smaller proportion of your portfolio over time. Regular rebalancing ensures your investment strategy stays aligned with your financial goals and risk appetite, effectively managing your portfolio's risk and return characteristics.

Importance of Portfolio Rebalancing

Portfolio rebalancing is important for two key reasons: risk management and the potential for improved returns. This is because a proper asset allocation plan is designed to both preserve and grow your portfolio. Without portfolio rebalancing, your portfolio is likely to drift from its target allocations, which are tailored to your personal risk-return profile, thereby resulting in uncertain performance outcomes and deviations from your investment goals.

Risk Management

Effective risk management through portfolio rebalancing involves periodically adjusting the portfolio to keep it aligned with a desired risk profile. This process is important as it helps maintain the intended diversification and balance between different types of investments. It goes without saying that a misaligned portfolio, which may be too aggressive or too conservative, is problematic, especially for retirees.

Consider the three-fund portfolio, a passive investment approach many investors follow due to its simplicity and low-cost investing. It typically consists of "total market" domestic stocks, international stocks, and bond index funds. The best-fit mutual funds for this three-fund portfolio from Vanguard are:

  • Vanguard Total Stock Market Index Fund (VTSAX)
  • Vanguard Total International Stock Index Fund (VTIAX)
  • Vanguard Total Bond Market Fund (VBTLX)

Investors would then simply buy and hold these funds until retirement, with the allocations being determined by the investor's desired asset allocation. This is influenced by a variety of factors, including the investor's risk tolerance, return expectations, time horizon, tax considerations, and more.

For our example, we'll assume that we invest equally in the three funds (~33.33% each), deploying a lump sum of $100,000 on the last trading of 2010. Here's how the portfolio allocations would change over the next 10 years if we don't rebalance the portfolio:

As you can see, over a decade-long time horizon, VTSAX, which provides exposure to the entire U.S. equity market and is notably tech-heavy, has increased its original portfolio allocation by just over 20%.

There are two key issues here in relation to risk management:

  1. Greater Market Volatility: Not rebalancing lets the market dictate risk. Stocks generally exhibit a higher risk-return profile and greater volatility compared to bonds. Although this can lead to higher potential returns, it also increases the likelihood of larger short-term fluctuations, which may not align with your investment goals.
  2. Reduced Diversification: Not rebalancing diminishes the portfolio's diversification benefits. Bonds (VBTLX), are typically less volatile and serve more as an income investment compared to stocks and can help offset equity risk. Meanwhile, international stocks (VTIAX) offer global exposure, potentially mitigating the impact of U.S. market downturns.

Clearly, the risk-return profile that the evenly distributed three-fund portfolio originally offered is now skewed toward a more aggressive stance, implying greater volatility and a higher potential for gains/losses. This may not be desirable, especially as you approach retirement. Proper risk management, in this case, would typically involve maintaining an even distribution or increasing your bond exposure through VBTLX.

The Schwab Center for Financial Research has also found that without rebalancing, a moderate portfolio not only missed out on recovery opportunities but also shifted toward being overly conservative during the Great Recession (2007-2009). Conversely, the same portfolio assumed excessive risk from 2009 to 2021 due to the lack of rebalancing, as visualized below:

"The portfolio above is composed of 60% stocks and 40% bonds on 10/31/2007, and is not rebalanced through 02/28/2009. It is rebalanced to 60% stocks and 40% bonds on 02/28/09 and not rebalanced through 12/31/2021. Asset class allocations are derived from a weighted average of the total monthly returns of indices representing each asset class. The indices representing the asset classes are the S&P 500 Index (stocks) and the Bloomberg US Aggregate Bond Index (bonds). Returns assume reinvestment of dividends and interest. Indices are unmanaged, do not incur fees and expenses, and cannot be invested indirectly." 

Schwab Center for Financial Research

This study demonstrates that rebalancing tends to reduce portfolio risk and also potentially improve long-term returns, although this can be dependent on the time period.

Potential for Improved Returns

Rebalancing also offers the potential to improve returns by systematically selling assets that have appreciated and buying those that are currently undervalued. Although this may seem counterintuitive because it requires investors to sell parts of an asset class that have performed well and replace them with assets that have not performed as well (or even poorly), this approach to buying low and selling high may lead to better long-term performance.

According to Pinnacle Advisory Group, this is especially true if you rebalance two or more asset classes that have similar long-term expected returns, such as REITs and high-dividend yielding stocks.

In a properly diversified portfolio, stocks are generally one of the more volatile assets, if not the most volatile, implying a greater expectation for returns. As previously demonstrated, stocks in a non-rebalanced portfolio will likely outpace the performance of other assets in your portfolio, thereby leading to potentially greater returns.

Although this may be true in a favorable market, shifts such as high-interest rate environments or recessions can make rebalancing a strategy for improving long-term returns. In other words, rising interest rates may increase bond values (e.g., VBTLX) and diminish the appeal of equities (e.g., VTSAX, VTIAX), prompting a rebalance from overvalued bonds to undervalued stocks, potentially enhancing returns over time.

For example, a State Street Global Advisors study on rebalancing during COVID-19 found that without rebalancing, a 60/40 portfolio (60% ACWI, 40% AGG) returned 5.51% from January to August 2020, with equity allocation fluctuating significantly. Conversely, a quarterly rebalanced portfolio yielded a 7.20% return, demonstrating less fluctuation and benefiting from a rebalancing premium during the equity rally in the second quarter. This highlights the advantage of reallocating assets based on market movements, dependent on their correlation and volatility.

To provide another example, a study by T. Rowe Price revealed that rebalancing with a fixed 3% threshold enhanced investment returns by more than $10,000, equating to an increase of 56 basis points (0.56%) in annualized returns over the ten-year period from July 11, 2005, to July 11, 2015, compared to a portfolio that was not rebalanced. This is shown in the visual below:

A Line Graph Comparing Investment Growth Over Time With Different Strategies: No Rebalance, Rebalancing To Sell Equities, And Rebalancing To Buy Equities.
Source: T. Rowe Price

"For illustrative purposes only. Based on a hypothetical portfolio consisting of eight market indices and cash, for a single 10-year period starting July 11, 2005. The hypothetical diversified portfolio uses a 90% target equity allocation (see table below). Rebalancing is based on the 3% fixed tolerance band method, as described in the article. We chose this starting date and 90% equity model to illustrate the way rebalancing could play out over the years and to be representative of a situation where the 3% fixed bands exhibited the best performance among methods tested. Results for different starting dates, and for the 30% and 60% equity models, would differ. Does not reflect fees. Cash is assumed to have 0% returns. Individuals cannot invest directly in an index. Past performance cannot guarantee future results."

T. Rowe Price

In closing, such strategic portfolio adjustments help investors not only mitigate risk but also capitalize on opportunities for improved returns by realigning their investment allocation with areas of the market that have higher growth potential. However, it's important to reiterate that the claim of "improved returns" depends on both the portfolio rebalancing strategy AND the period during which the rebalancing was conducted.

The State Street Global Advisors study discussed previously, for instance, claimed that quarterly rebalancing during the COVID-19 recession led to improved returns in 2020. However, in reality, it's not always advisable or practical to rebalance your portfolio on a quarterly basis. In fact, a study from Vanguard found that too-frequent rebalancing is not cost-efficient nor optimal for risk and return, as we'll discuss more in-depth later.

Portfolio Rebalancing Strategies

In this section, I'll discuss the different strategies to rebalance a portfolio, their nuances, and highlight the pros and cons of each strategy. Rebalancing is preferable to not rebalancing due to risk management and the potential for improved returns, as previously discussed. In general, a combination of periodic annual rebalances and threshold-based triggers is the most advisable approach.

Calendar-Based Rebalancing

Calendar-based rebalancing simplifies the portfolio management process by aligning it with specific dates or events throughout the year, ensuring discipline and regularity. This approach, simply based on time, entails establishing a routine schedule to realign the portfolio with its target allocations.

A Vanguard study highlights the importance of consistent rebalancing, deeming annual rebalancing as "optimal" for investors not engaged in tax-loss harvesting or closely tracking a benchmark portfolio, like passive funds-of-funds. It also found that more frequent rebalancing, such as quarterly or monthly, doesn't yield additional advantages.

However, strategies that are more aggressive or use leverage may benefit from more regular rebalances, such as quarterly or semi-annually, to address quicker allocation changes.

Calendar-based rebalancing can also be strategically aligned with certain times of the year or specific financial events to maximize benefits and efficiency, as discussed below:

  • April (Tax Preparation): Aligning rebalancing with tax preparation offers the opportunity to review and adjust your portfolio with a clear understanding of your tax situation. This timing allows investors to make informed decisions that could lead to tax savings, especially if rebalancing involves selling assets that could trigger taxable events.
  • December (Year-End Tax-loss Harvesting): December is ideal for tax-loss harvesting, where investors can sell investments at a loss to offset capital gains taxes. Rebalancing during this time enables investors to adjust their portfolios while potentially reducing their tax liability for the year.
  • Receiving a Bonus or Significant Income: Choosing to rebalance when receiving a bonus or significant income allows investors to use new funds for adjusting their portfolios, following the cash flow rebalancing method. This strategy avoids the need to sell existing investments, which could incur taxes or transaction fees, and provides additional flexibility in meeting targeted asset allocations.

By selecting these strategic times for calendar rebalancing, investors can effectively manage their portfolios to align with both their investment strategy and tax planning goals, optimizing financial outcomes without unnecessary tax consequences.

While calendar-based rebalancing offers simplicity and is better than not rebalancing at all, it comes with its own set of limitations:

  • Missed Market Opportunities: Strict adherence to a calendar for rebalancing may miss out on buying assets at their most favorable prices. For example, during the COVID-19 recession in early 2020, a predetermined rebalance schedule would have missed the opportunity to buy significantly dropped stock prices in February and March, foregoing the ideal time to purchase at lower values.
  • Unnecessary Adjustments: In years when all asset classes perform similarly, there might be little to no need for rebalancing. This highlights how calendar rebalancing's effectiveness depends on market volatility, as uniform performance across assets eliminates the need for realignment.
  • Judgment-Based Approach: Calendar-based rebalancing could be seen as a judgment-based approach, resembling market timing, which is challenging to execute successfully over the long term and susceptible to behavioral biases.

These drawbacks highlight the importance of flexibility and responsiveness in portfolio management, suggesting that while calendar rebalancing can provide structure, it may also benefit from adjustments based on market conditions and investment performance.

Threshold-Based Rebalancing

Threshold-based rebalancing is a dynamic strategy that adjusts a portfolio's composition based on its performance, employing predefined criteria for rebalancing. This method responds to deviations from the target asset allocation, triggering rebalancing actions when investments exceed specified levels, rather than relying on an arbitrary date like calendar-based rebalancing.

There are two main types of tolerance bands investors should be aware of:

  • Fixed Bands: Fixed bands are set as specific percentage points away from the target allocation, requiring rebalancing when actual allocations surpass these predetermined thresholds. For instance, in a 60/40 stock/bond portfolio, a 10% fixed band necessitates rebalancing if the stock allocation rises to 70% or falls to 50% of the portfolio. This approach offers a clear and actionable guideline for maintaining the desired balance between asset classes.
  • Relative Bands: Relative bands are determined as a percentage of an asset class's target allocation, adjusting for changes in proportion to its original weight. In a 60/40 stock/bond portfolio with a 10% relative band on the 60% stock allocation, rebalancing is triggered when the stock portion reaches 66% (an increase of 10% of 60%) or declines to 54% (a decrease of 10% of 60%). This method ensures rebalancing occurs when there's a significant proportional shift from the intended allocation, aiding in the preservation of the portfolio's strategic composition.

It's important to recognize that with relative bands, the likelihood of triggering a rebalance is similar for investments, regardless of their size within the portfolio. Conversely, with fixed bands, rebalancing is more often prompted by larger investments straying beyond their set thresholds. For instance, a smaller shift in the market is needed to alter an investment's allocation from 30% to 35% compared to changing from 5% to 10%, due to the proportional nature of market movements.

Both fixed and relative bands have their merits, with fixed bands offering simplicity and consistency while relative bands provide a more tailored approach based on individual investment positions. For a deeper understanding, the T. Rowe Price study mentioned previously offers an in-depth comparison of not rebalancing and using relative and fixed bands at different band sizes.

While threshold-based rebalancing overcomes the limitations of calendar-based rebalancing by aligning rebalancing efforts with market movements and actual portfolio performance, offering a precise way to maintain asset allocation over time, it presents two main challenges:

  • Continuous Monitoring: Threshold rebalancing requires ongoing portfolio observation to identify when allocations surpass predetermined bands, which may not be feasible for retail investors managing their portfolios.
  • Potential for Frequent Rebalancing: Though it can offer cost savings by avoiding the over-frequent adjustments seen with purely calendar-based strategies, threshold rebalancing may lead to more regular rebalancing, especially with narrow tolerance bands, potentially increasing costs as well.

Thus, while threshold rebalancing provides a targeted approach to maintaining portfolio balance, it demands significant attention and may increase transaction costs, underscoring the need for investors to carefully consider their strategy's feasibility and cost-effectiveness.

Comparison: Not Rebalancing, Annual Rebalancing, and 5% Fixed Threshold Rebalancing

Let's revisit our initial three-fund portfolio example, consisting of "total market" domestic stocks (VTSAX), international stocks (VTIAX), and bond index (VBTLX) funds.

We'll demonstrate how an evenly distributed allocation (~33.33% each) with a $100,000 investment made on the last trading day of 2010 would have performed over the next decade using three different rebalancing strategies: not rebalancing, annual rebalancing (on the first trading day of each year), and rebalancing when any asset exceeds a 5% fixed threshold.

If you're interested, the StableBread dataset for this example is provided in the spreadsheet linked below:

First, here's how the overall portfolio values grew across the different portfolio rebalancing strategies:

As you can see, not rebalancing the portfolio in this specific case led to the greatest returns, as summarized in the table below:

It's also worth understanding the amounts rebalanced from each of the three funds over time (to maintain the even ~33.33% portfolio split), and specific to threshold-based rebalancing, the frequency of rebalancing, as the tables below demonstrate:

Annual Rebalancing
5% Fixed Threshold Rebalancing

The tables above show that 5% fixed threshold rebalancing didn't trigger annually like the calendar-based approach but resulted in more transactions during market volatility, particularly in the 2020 COVID-19 recession, leading to higher overall rebalancing costs, which may suggest a higher overall tax/cost implication. This outcome highlights the simplicity of annual rebalancing and, in this instance, a 31 basis point (0.31%) improvement in CAGR (8.01% - 7.70%) with fixed threshold rebalancing (at 5%), not considering potential selling costs.

This also explains why both rebalancing methods fell short compared to not rebalancing; they shifted investments from the higher-growth yet riskier U.S. equities (VTSAX) to lower-yielding international stocks (VTIAX) and bonds (VBTLX). Meanwhile, the non-rebalanced portfolio maintained and grew its stake in VTSAX throughout the decade, boosting the portfolio's returns.

We can also compare the portfolio allocations across the three rebalancing strategies and see how they changed over time:

The bottom line is that both annual calendar and threshold-based rebalancing approaches are suitable for maintaining an evenly distributed portfolio allocation over the 2010-2020 decade. Adjusting the dates of annual rebalances, changing the fixed threshold balance to a relative tolerance approach, or choosing a different timeframe than 2010 to 2020 would obviously affect the results shown here.

For instance, opting for a 10% fixed threshold instead of 5% might narrow the returns gap seen with not rebalancing, thanks to fewer trades and bigger buying chances in the COVID-19 recession when stock prices were lower.

Lastly, although further analysis on risk-adjusted performance can be conducted, the goal here is to provide a high-level comparison overview of the three rebalancing strategies.

Calendar- and Threshold-Based Rebalancing

Calendar- and threshold-based rebalancing combines the discipline of time-based rebalancing with the responsiveness of threshold-based approaches. This hybrid method optimizes portfolio management by establishing a regular rebalancing schedule and adapting to significant market movements that push asset allocations beyond predefined tolerance levels.

Here's how it works:

  • Scheduled Monitoring: Investors set a regular timeline for portfolio review, such as semi-annually or annually, ensuring consistent evaluation against strategic asset allocation and financial goals. This maintains a disciplined approach to portfolio management.
  • Threshold Flexibility: Beyond the regular schedule, this strategy employs threshold triggers for rebalancing. Thresholds should not be too large, to avoid tracking error while minimizing costs, nor too small, to reduce tracking error at the expense of potentially higher costs. If an asset class’s allocation diverges by a predetermined percentage from its target, indicating a significant shift in portfolio balance, rebalancing is recommended, even outside the usual monitoring period.

This approach offers a balanced solution that combines the advantages of both calendar-based and threshold-based rebalancing, ensuring consistent maintenance while accommodating adjustments in response to significant market events. This is particularly advantageous in volatile markets, where waiting until the next scheduled review could overlook essential adjustments.

Although this method doesn't directly solve the issue of continuous monitoring required by threshold-based rebalancing, setting suitable bands and periodically monitoring market news and investment performance should alert investors to the necessity of unscheduled rebalancing.

Moreover, leveraging automated rebalancing features, such as redirecting cash from dividends and/or bond income into underweight areas of the portfolio, along with utilizing alert systems provided by some investment services, can reduce the need for active portfolio rebalancing.

Constant Proportion Portfolio Insurance (CPPI)

Constant Proportion Portfolio Insurance (CPPI) is a strategy that dynamically adjusts the allocation between risky and conservative asset classes. This adjustment is based on a predefined portfolio "floor," dividing investments into a "cushion" for preservation and a segment for growth. The strategy's aim is to balance capital preservation with the opportunity for appreciation, by maintaining a part of the portfolio for stability and another for growth potential.

The key principles of the CPII approach are as follows:

  • Preservation vs. Growth: CPPI splits the portfolio into a conservative segment for security and a riskier one for capital appreciation, creating a balance that protects against downturns while seeking greater upside potential.
  • Adaptable Allocation: Unlike fixed rebalancing strategies, CPPI flexibly adjusts the mix of conservative and aggressive investments according to the portfolio's performance and the investor's changing needs, allowing for tailored growth opportunities while ensuring a foundational safety buffer.

Consider a scenario where you aim to balance your portfolio between conservative assets for income and preservation, and aggressive growth assets, with an initial 60/40 stock/bond fund setup. Here, 60% is for growth, and 40% serves as a cushion for essential expenses.

If the portfolio's total value significantly rises, the absolute amount for preservation may not need to proportionally increase if your financial needs stay the same. Therefore, if our 60/40 stock/bond portfolio grows from $5M to $10M, the original $2M cushion might still cover essential expenses. Thus, maintaining this $2 million cushion would adjust the portfolio to an 80/20 stock/bond ratio (after rebalancing), offering more growth opportunities without compromising the needed safety.

This approach may not be suitable for all investors but can be effective given these two main considerations:

  • Regular Monitoring and Adjustments: This strategy requires vigilant oversight to ensure the cushion adequately covers short-term needs while aiming for long-term growth. Continuous assessment allows for timely adjustments in response to market fluctuations and portfolio performance, helping to maintain the desired balance between risk and return.
  • Stable Lifestyle Costs and Risk Tolerance: It operates on the premise of stable lifestyle expenses and the investor's ability to withstand increased portfolio volatility and risk from a higher stock allocation. This assumes an awareness of inflation and lifestyle creep, ensuring financial needs are met consistently, even as market conditions and personal spending habits evolve. Investors must be comfortable with broader market swings to leverage this strategy effectively.

In essence, CPPI allows for more aggressive investments in growth assets as the portfolio's value climbs, keeping a safety cushion that doesn’t proportionally increase with the portfolio. This method therefore provides a refined alternative to traditional rebalancing strategies, potentially boosting returns for those prepared to accept additional risk, without sacrificing the security provided by the preservation portion.

How to Rebalance Your Investment Portfolio

Rebalancing your portfolio ensures your investments remain aligned with your financial goals, risk tolerance, and time horizon. This section aims to provide a comprehensive overview of the different approaches investors can take to rebalance their portfolio. Each of these strategies has its own set of pros and cons that are worth understanding as well.

Sell and Redirect

The sell and redirect method is a straightforward approach that involves selling portions of assets that have outperformed and redirecting the proceeds into underweight asset classes.

For instance, in a portfolio initially set to a 60/40 stock-to-bond fund ratio, if the stock fund grows significantly more than the bond fund, causing a 70/30 skew, you would sell some of the stock fund and buy the bond fund to restore the original allocation.

Pros:

  • Maintains Target Asset Allocation: Effectively manages risk by keeping the portfolio aligned with the investor’s risk tolerance and objectives, preventing any asset class from skewing the risk profile.
  • Capitalizes on Gains From Overperforming Assets: Allows investors to secure profits from well-performing assets, reallocating these gains to bolster underperforming and undervalued assets, which encourages profit-taking discipline.
  • Potentially Improves Risk-Adjusted Returns: Enhances long-term potential by reallocating to underperforming assets, especially beneficial in tax-advantaged accounts like IRAs or 401(k)s, where adjustments don't incur immediate tax implications.

Cons:

  • May Incur Transaction Costs and Taxes: Impacts net returns in taxable accounts through potential capital gains taxes and fees. Tax-loss harvesting can offset these by balancing gains with losses.
  • Requires Active Monitoring and Decision-Making: Necessitates a proactive approach, with investors needing to monitor portfolio performance and market trends closely for timely rebalancing.
  • Risk of Overtrading: Increased transaction costs and reduced returns can result from frequent rebalancing. This risk is minimized by focusing rebalancing efforts on tax-advantaged accounts and using cash contributions in taxable accounts to purchase underweight assets (as discussed below), avoiding the sale of investments that trigger capital gains taxes.

Cash Flow Rebalancing

The cash flow rebalancing method is a rebalancing strategy that involves using new cash inflows to buy more of the underperforming or underweight assets in your portfolio, rather than selling overperforming assets to rebalance.

Revisiting our earlier scenario with a portfolio initially at a 60/40 stock-to-bond ratio that grows to a 70/30 skew, you could instead use new cash to purchase more bonds. This action would restore the original 60/40 allocation without needing to sell any stocks.

Pros:

  • Maintains Target Asset Allocation: This method also helps in keeping the portfolio aligned with the investor’s risk tolerance and objectives by adjusting the asset allocation back to its target without needing to sell assets.
  • Potentially Improves Risk-Adjusted Returns: Utilizing cash flow rebalancing to allocate to underperforming assets can also enhance the long-term potential of the portfolio.
  • Avoid Selling Costs and Taxes: By not selling assets, this approach avoids transaction fees and potential capital gains taxes, making it particularly advantageous in taxable accounts.
  • Simplifies Rebalancing Process: Using new cash inflows, stock dividends, or bond interest payments to buy underweight assets simplifies rebalancing. Many brokerages can automate this, eliminating the need to choose which assets to sell.

Cons:

  • Dependent on Availability of Capital: This method requires new cash for investment, which may not always be readily available, limiting its effectiveness and the speed at which the portfolio can return to its target allocation.
  • Challenges in Rapid Markets: In fast-moving markets, relying solely on new cash inflows for rebalancing may lead to missed opportunities for optimal portfolio adjustment, as this strategy can be slower compared to selling overperforming assets.

Withdraw First

The withdraw first strategy is particularly suited for retirees, involving the use of distributions from overrepresented assets to rebalance the portfolio. This means withdrawing from assets that have exceeded their target allocation until the desired balance is achieved.

For example, in a portfolio initially set at a 60/40 stock-to-bond ratio, if the stock portion appreciates causing a 70/30 ratio, you would withdraw from the stock fund to cover expenses until the allocation returns to the original 60/40 setup.

Pros:

  • Maintains Target Asset Allocation: Again, this method ensures the portfolio stays aligned with planned risk tolerance and objectives by reducing overweight assets.
  • Potentially Improves Risk-Adjusted Returns: Again, this method can potentially improve long-term returns by reducing reliance on overvalued assets and preserving the balance, beneficial for managing overall portfolio risk and return.
  • Utilizes Gains Efficiently: By drawing from overvalued assets for living expenses or other needs, retirees can use the growth of their investments effectively without disturbing the balance of underperforming assets. Typically, this means withdrawing from stocks or growth portions, preserving the more conservative bond investments as stocks generally grow to become a larger portion of the portfolio over time.

Cons:

  • May Trigger Tax Implications: Withdrawals from certain accounts could lead to taxes, affecting net returns, although strategically choosing from which account to withdraw can mitigate this entirely.
  • Requires Strategic Planning: This approach demands a clear understanding of which assets to withdraw from to achieve rebalancing without compromising the portfolio's growth potential.

Not Rebalancing

Not rebalancing a portfolio can be a strategic decision influenced by various factors. The scenarios below describe situations in which it may not make sense to rebalance your portfolio:

  • Early Wealth Accumulation: Young investors focusing on growth might opt for equity-heavy portfolios and delay rebalancing until closer to retirement, gradually transitioning to a more balanced asset mix. This approach is viable because they have a longer time horizon, allowing for greater tolerance of downside portfolio risk.
  • Use of Target Date Funds: Investors in target date funds, which automatically become more conservative as retirement approaches, likely do not need to manually rebalance their portfolios. For instance, a 25-year-old targeting retirement around 2065 could invest their capital into a fund like the Vanguard Target Retirement 2065 Fund (VLXVX), entrusting portfolio management and rebalancing to professionals.
  • Automatic Portfolio Rebalancing: Some investment brokerages offer services that automatically reinvest dividends, bond income, and new cash reserves (e.g., regular monthly contributions), into underweighted assets within the portfolio. This feature allows for continuous, hands-off rebalancing, keeping the investment allocation in line with the investor's chosen strategy without manual intervention.
  • Strategic Asset Allocation Changes: Investors who alter their strategic asset allocation in response to new financial goals or changes in risk tolerance might forgo rebalancing to align with their updated investment strategy.
  • Market Timing or Tactical Asset Allocation: Some investors may choose not to rebalance if they anticipate certain market sectors will outperform and wish to maintain an overweight position in those areas, despite the associated risks of market timing.
  • High Transaction Costs: Although less common, avoiding rebalancing to minimize the impact of significant transaction fees is another scenario where not rebalancing can preserve overall returns.
  • Tax Considerations: In taxable accounts, the potential tax impact from selling assets to rebalance might lead investors to minimize or delay rebalancing activities to safeguard their after-tax returns.

These factors, ranging from the investor's life stage and use of specific investment products to considerations about costs, taxes, and strategic planning, can influence the decision to forgo portfolio rebalancing in favor of an approach better suited to the investor's circumstances and goals.

The Bottom Line

Portfolio rebalancing is important as it enables investors to manage risk and enhance potential returns in their investment portfolios. By adjusting the allocation of assets in a portfolio, rebalancing helps maintain a desired level of risk and can capitalize on market fluctuations to buy low and sell high, ensuring investments remain aligned with an investor's goals and risk tolerance.

Portfolio rebalancing strategies include "calendar-based rebalancing," which simplifies the process by scheduling rebalances at regular intervals, with annual rebalancing being optimal for most investors. "Threshold-based rebalancing" triggers adjustments when asset allocations deviate by a certain percentage, providing a more responsive approach to market changes. A combination approach integrates both calendar and threshold-based methods for a balanced solution. "Constant Proportion Portfolio Insurance (CPPI)" dynamically adjusts between conservative and growth assets based on portfolio performance and predefined floor values, offering a nuanced alternative for managing risk and return.

There are several approaches to rebalancing a portfolio, each with its unique considerations. The "sell and redirect" method involves selling overperforming assets to buy underperforming ones, ensuring the original asset allocation is maintained. "Cash flow rebalancing" uses new cash inflows to purchase underweighted assets, avoiding the need to sell. The "withdraw first" strategy is particularly useful for retirees, drawing from overvalued assets to rebalance. Lastly, some investors may simply choose not to rebalance, depending on specific circumstances or investment philosophies.

In closing, to manage their portfolio's risk and potentially achieve higher returns, investors should select a suitable portfolio rebalancing approach and commit to it for the long term, rather than allowing market fluctuations to dictate their risk level. The key is to give your portfolio enough room to breathe and grow, ensuring it doesn't become too unbalanced, while minimizing potential fees and tax consequences from rebalancing.

Disclaimer: Because the information presented here is based on my own personal opinion, knowledge, and experience, it should not be considered professional finance, investment, or tax advice. The ideas and strategies that I provide should never be used without first assessing your own personal/financial situation, or without consulting a financial and/or tax professional.

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