It’s Time To Smart Rebalance Your Portfolio. Here is Why, When, and How.

Posted April 30, 2020

In Asset Allocation, Financial Planning, Investing, Tax Planning

When should you rebalance your investments? As with many questions, the best place to start is with why. Why should we rebalance in the first place? Your asset allocation, how you allocate your savings to different investments, is a key element of an investment strategy. It represents the risk-return tradeoff you are willing to make to achieve your investment goals. You typically arrive at your asset allocation through a process that includes goal setting and understanding your risk tolerance and risk capacity. Your asset allocation, not timing market cycles or picking stocks, determines 90% of how your investment is going to perform in good and bad times.

Why

So why rebalance? Having a portfolio on target all the time helps you make sure your investments are ready to benefit from the growth opportunities that markets have to offer while managing key risks for your goals. Take risk management. On average, you expect risky stocks over time to grow faster and become a larger fraction of your investments. Left unchecked, the risk you are taking with your investments increases over time. Rebalancing helps you prevent that. A benefit from this approach is that over time you expect to harvest some of the growth and turn it into safer investments, locking in the gains.

Rebalancing makes sense after periods of poor stock performance too. If stocks underperform, the risk level of your portfolio, which is related to its potential future growth, may be too low for your risk capacity and risk tolerance (the last two are different concepts, see here). Rebalancing optimizes your portfolio to capture potential future gains should the market rebound. Large market gains are often achieved in a matter of days or weeks, so having the portfolio ready to benefit from upside while maintaining the right risk exposure in your portfolio can make a difference to long-term returns.

Not just stocks vs bonds

While the rebalancing question is often framed in terms of the mix between stocks and bonds, it is more general than that. While we advocate broad market diversification, not all stocks are the same. Different stocks have different risk-return characteristics, as we discussed here, so rebalancing should take into account your mix of large, small, value, growth, and quality stocks. Similarly, your bonds should match the risk management strategy for your goals, as we discussed here. So rebalancing is very important across bond and bond funds too.

A classic tradeoff

The lesson is this. If there was no cost to rebalancing, you should rebalance to your target allocation every day. And why not? If you are a cyclist, rebalancing is like checking the drivetrain and lubing the chain of your bicycle before every ride. A smooth drivetrain determines 90% of the enjoyment of your ride, believe me. And investing should be a long, long ride.

Of course, in reality, there are some costs to rebalancing. The time it takes to monitor our investments, trading costs, and taxes. We have a classic tradeoff, so how do we address it?

Back to When

With rebalancing, the most common strategy is to do it at regular intervals, one to four times a year, and let the portfolio drift between rebalance dates. While convenient, this approach is suboptimal. You may be very close to your target on your rebalance date, only to be very far off two weeks later. Ask anybody who rebalanced in February of this year.

A better approach is to allow the portfolio to drift within set limits, and minimize costs while rebalancing back to target if the limits are crossed. This approach uses the flexibility that is typically built in a good asset allocation and takes advantage of your cash flows to reduce costs or even turn them into opportunities. For example, you may decide that your target allocation to US stocks should be 40%, but it’s OK for your plan if it’s within the 37% to 43% range. You only rebalance when market moves are large enough to bring the allocation outside the bands. With this approach, it’s not how frequently you need to rebalance, but when and how. You are more likely to change after large market movements, when the benefits of doing so are also greater, instead of a set date.

How to smart rebalance

How to set the bands depends on your strategy and the type of investments you hold. Common bands are between 2 and 5%. In our US stock example, the band is 3% (you take the range and divide by two = (43% – 37%)/2). Bands can be tighter with tax-advantaged accounts, since the costs of rebalancing there are typically smaller. After you set the bands, you monitor your portfolio. If your investments fall outside the bands, you readjust to target. Here is a logic to minimize costs while doing so.

Use your cash flows

A simple way to rebalance without additional tax implications is to use the dividend distributions you receive from your funds. If you need to reduce the allocation to a particular fund, do not reinvest the distributions in the fund. Direct them to the funds that are most underweight (have the lowest allocation relative to the target). Next, use your deposits. If you save biweekly from your paycheck, every deposit is an opportunity to rebalance at no cost. Direct your distributions to the most underweight investments. If your portfolio is drifting and you have a deposit coming, consider making the deposit early to rebalance. Turn rebalancing into an opportunity for extra savings.

Your withdrawals can help just as much as your inflows. You can use withdrawals to rebalance by selling investments that are overweight first.

Be smart about taxes

Consider potential gains and losses on your funds when rebalancing. For every sell trade (whether you rebalance or not), it is good practice to minimize tax implications by selling lots with the lowest tax impact first. If you contribute regularly, you have many lots to choose from. Since short-term capital gains are taxed at a higher rate than long-term gains, you may want to allow your portfolio to drift outside the bands instead of realizing a short-term gain.

With this approach you may wonder how closely you need to monitor your portfolio, and whether it generates more trading than a standard approach. The answer is that you want to monitor your portfolio every day, but make changes only when your allocation is outside the bands. Over the course of a year you may end up trading similar amounts or less than standard approaches, since you consistently use cash flows to rebalance.

Smart rebalancing consistently positions your investments to benefit from growth opportunities while keeping your risk profile aligned with your goals, at a similar or lower cost than potential approaches. So there is very little reason not to do it. Remember that small gains over the long term add-up, so why pass it up?

While this sounds like more work, consider that smart technology can automate it. At DESMO, We use technology from Betterment to implement it. So take a look, or get in touch with us if you want to learn more.

Until Next Time!

Massi De Santis is an Austin, TX fee-only financial planner. DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow, and protect their resources throughout their lives. As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.