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Have you been investing in stocks, bonds, or other asset classes? If you have, have you been rebalancing? If not, you should be, and that’s what today is all about! I will share everything you need to know about portfolio rebalancing, including five portfolio rebalancing strategies that can help you build more wealth with less risk.
What is Portfolio Rebalancing, and Why is it Important?
First, what is portfolio rebalancing? Depending on your age, investing goals, and risk tolerance, you likely have a portfolio allocation in mind (if not, check out our guide on How to Start Investing). For example, maybe your target portfolio is 70% stocks and 30% bonds.
The problem is, this composition gets out of whack over time. For example, if the stock market has a banner year, you may have 80% stocks and 20% bonds instead of the 70/30 allocation you were targeting.
Rebalancing is the process of restoring the target composition of your portfolio.
So, why does this matter? The simple answer is that you designed your target allocation based on your risk tolerance and goals. When your portfolio gets out of balance, your portfolio will carry different risk and return characteristics than what you wanted.
Okay, that’s great, but is rebalancing really necessary? Let’s look at the facts.
Does Portfolio Rebalancing Actually Improve Returns?
When your allocation shifts, it is often because of certain asset classes outperforming. Generally, this outperforming asset class is equities (stocks), which carry more risk. Rebalancing usually means selling this outperforming asset class and purchasing an underperforming asset class. So, what impact does this have on returns?
Let’s get a little geeky. Vanguard has done this analysis for us, projecting 30 years of returns based on 10,000 market return scenarios. Here’s what they found.
A non-rebalanced portfolio is more likely to produce higher returns. But, and this is a big but, it is also more likely to have lower returns. Additionally, a non-rebalanced portfolio likely experiences a much higher level of volatility.
A metric called the Sharpe ratio measures how much return there is per unit of risk. Here’s what Vanguard found. A rebalanced portfolio produces a higher Sharpe ratio.
Said differently, a rebalanced portfolio produces a higher return per unit of risk. This is a crucial point. If you take nothing else away from this article, make it this. A rebalanced portfolio produces better risk-adjusted returns.
To learn more about rebalancing and its impact on returns and risk, I would encourage you to check out the Vanguard study.
How do you Rebalance Your Portfolio?
To rebalance your portfolio, you’ll have to buy and sell certain assets to bring your portfolio allocation back in line with your target. There are several strategies you can use to rebalance. Let’s cover the common portfolio rebalancing strategies.
Countless Ph.D. theses have been written on this topic. My goal is not to give you the Ph.D. thesis approach but rather give you several easily implementable solutions.
Strategy No. 1: Calendar Rebalancing
The most common rebalancing strategy is calendar-driven. What this means is that you rebalance your portfolio at set intervals.
For example, you may choose to rebalance your portfolio once per year. This strategy is easy to implement because you can do it when other financial events are on your mind (such as year-end, tax time, etc.).
Of course, the next question is at what interval should you rebalance if rebalancing on a calendar schedule (annually, quarterly, monthly, etc.). Let’s come back to that in a minute after we cover some of the other portfolio rebalancing strategies.
Strategy No. 2: Threshold Rebalancing
The next rebalancing strategy uses what I’ll call a threshold trigger.
Imagine once again that your target portfolio allocation is 70% stocks and 30% bonds. With this rebalancing strategy, you set a band within which portfolio variation is acceptable. If the portfolio deviates from this band, rebalance your portfolio.
For example, perhaps you have a 5% band whereby if your allocation deviates by +/- 5%, you do nothing. If your allocation varies by more than 5%, a rebalancing is triggered.
This approach can have some interesting effects. Take the stock market implosion in March 2020. At the time, the S&P 500 fell by more than 30%.
For most folks using a threshold rebalancing approach, this would have triggered a rebalancing event. If rebalancing during the down market, you would have likely sold bonds and purchased stocks. What impact would this have had? You would have bought stocks when they were relatively cheap and outperformed during the stock market bounce.
Strategy No. 3: Rebalance When You Buy
A third portfolio rebalancing strategy is to rebalance when you invest additional money. For example, let’s assume that bonds are underweight in your portfolio. The next time you invest money, purchase bonds to help bring your portfolio back in balance.
This approach is easy and efficient because you minimize transaction costs (such as trade commissions and potentially capital gains taxes on asset sales).
Strategy No. 4: Isolate Accounts
While the first three strategies are the main ones to consider, I want to share another nuance to rebalancing.
Let’s assume you have three investment accounts: a 401(k), an IRA, and a taxable brokerage account.
In this case, rebalancing can get tricky. Rather than just rebalancing a single account, you now have multiple accounts to consider.
One such solution to this conundrum is to rebalance each account in isolation. For example, each of your 401(k), IRA, and taxable brokerage account could be with a 70%/30% mix of stocks and bonds.
While this may make the math a little easier, it’s not the approach I recommend. Why? Because certain types of assets are more tax-efficient than others and thus belong in different accounts
As an example, bond income is taxed as ordinary income, while stocks are often more tax-advantaged in that much of the gains are taxed at the more favorable capital gains rates.
In practice, this means that you should hold non-tax-efficient asset classes (like bonds, REITs, etc.) in tax-advantaged accounts and tax-efficient asset classes (like stocks) in taxable accounts (to the extent you’ve already maxed out tax-advantaged accounts).
Investment placement by account type is a rabbit hole in itself, but the bottom line is that if you can put the right asset classes in the right kind of account, you can do better. But how does this work from a rebalancing perspective? It means you must aggregate your accounts.
Strategy No. 5: Aggregate Accounts
Let’s use a simple example. Assume you have two accounts, an IRA and a taxable brokerage account. Let’s assume you have $80,000 of stocks in your taxable brokerage account and $20,000 of bonds in your IRA to maximize tax efficiency. Remember, bonds aren’t tax-efficient, so they belong in a tax-advantaged account.
If your target portfolio is 70% stocks and 30% bonds, rather than rebalancing these accounts in isolation (as outlined in strategy #4), you’ll aggregate these accounts to figure out how to rebalance.
So, between the two accounts, you have $100,000, which means you want $70,000 of stocks and $30,000 of bonds in aggregate across your accounts. In this case, you’d sell $10,000 of stocks in your taxable account and then buy $10,000 of bonds.
When you have multiple accounts, things can get complicated, but the bottom line is to bring your portfolio into balance across your accounts in aggregate.
How Often and When Should You Rebalance Your Portfolio?
Now that we’ve covered some key portfolio rebalancing strategies let’s discuss how often and when to rebalance.
First, how often should you rebalance? The answer: it doesn’t matter as long as you stick to an approach.
Vanguard’s study looked at monthly, quarterly, and annual rebalancing (strategy number 1 – calendar rebalancing). The returns across these rebalancing intervals were nearly identical. And, importantly, all of these rebalancing strategies produced higher risk-adjusted returns than a non-rebalanced portfolio.
How about a threshold rebalancing approach? Vanguard looked at rebalancing with a 0%, 1%, 5%, and 10% threshold.
What was the result? It doesn’t matter. And, again, all of these threshold rebalancing approaches produced superior risk-adjusted returns relative to the non-rebalanced portfolio.
What’s the takeaway? Any consistent approach to rebalancing beats not rebalancing at all.
My advice? Keep it simple. Don’t rebalance too frequently (as it’s time-consuming and leads to higher transaction costs and tax burdens). Pick a set calendar or deviation threshold and stick to it.
How Do you Rebalance a Portfolio without Paying Taxes?
One criticism of rebalancing is that it can trigger taxable events (in particular, selling assets at a capital gain). Here are a few best practices when it comes to rebalancing to minimize your tax burden:
1) Rebalance Inside of Tax-Advantaged Accounts
Do your buying and selling inside IRAs, 401(k)s, and other tax-advantaged accounts.
Doing so will avoid taxable events. While it works best when you have multiple asset classes to shuffle around inside of a tax-advantaged account, try to take advantage to the fullest extent possible.
Vanguard’s analysis found that rebalancing inside tax-advantaged accounts increased after-tax returns by 0.44% per year without any increase in risk.
2) Rebalance with Purchases
As mentioned in strategy #3, rebalancing through buying rather than selling can be more tax-efficient.
Invest lump-sum investments, dividends, interest income, etc. in underweight asset classes.
If you must sell shares to rebalance, selling those with a higher cost basis will minimize capital gains.
Alternatively, if you tax-loss harvest, you can sell shares at a loss to offset gains on other asset sales to minimize the net tax burden.
Other Common Rebalancing Questions
While I’ve covered most of the most common questions about rebalancing, here are a few others to consider.
Who Does Not Need to Rebalance?
While most people should rebalance their portfolio, there are a couple of exceptions.
If you’re invested entirely in target-date funds (e.g., a retirement 2060 fund), you do not need to rebalance. Target date funds will automatically rebalance to align with the portfolio objectives.
Second, if you use a robo-advisor service like Betterment or Wealthfront, these accounts are automatically rebalanced, so there’s nothing for you to do.
Should You Rebalance in a Down Market?
While many folks wonder if they should rebalance in a down market, my answer here is simple. Rebalance in a down market if that’s what your rebalancing strategy dictates.
If you use a threshold strategy that dictates buying when your portfolio allocation is out of kilter, then yes, rebalance. If you use a calendar-driven approach and it’s not that time of the year, don’t worry about rebalancing.
The key to rebalancing is picking an approach and sticking to it. Over long periods, this works.
What’s the Best Portfolio Rebalancing Tool?
Finally, rebalancing can be complicated, particularly if you have multiple accounts with different financial institutions. There are two different ways to handle tracking your portfolio allocation.
First, the old-fashioned way. Make an Excel spreadsheet and input your total portfolio value across all accounts. Multiply this value times your target allocation for each asset class. This will tell you what your allocation should be.
Then, sum up your actual allocation by asset class. Figure out the difference (both in actual dollars and in percentage terms). This will show you where your portfolio is overweight/underweight and what needs to be rebalanced.
Unfortunately, when you have multiple accounts and multiple investments, things can get complicated pretty quickly. The easiest way to understand your allocation across accounts is to use a tool like Personal Capital, which aggregates accounts to show you your overall portfolio.
Personal Capital is the tool that I use to track my portfolio allocation, simply because it is always up to date and extremely easy to use for rebalancing.
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Portfolio Allocation Strategies to Build More Wealth with Less Risk: A Summary
When it comes to portfolio rebalancing strategies, pick a strategy and stick to it. Don’t overthink it, and don’t change your plan often – it’ll drive you crazy and end up being quite costly.
Remember that portfolio rebalancing costs money. You may incur trading commissions and taxable events. Speak to your financial professional before rebalancing to make sure that you understand the potential costs of doing so.
That said, rebalancing is one of the best ways to improve the risk-adjusted returns of your portfolio. More wealth. Less risk.
Five strategies to consider for rebalancing are:
- Calendar Rebalancing
- Threshold Rebalancing
- Rebalance When you Buy
- Isolate Accounts
- Aggregate Accounts
If rebalancing seems complicated, use a tool like Personal Capital to track your portfolio allocation. Or, if you want to make it even easier, use a robo-advisor like M1 Finance or Acorns, so you never have to worry about rebalancing at all.