Rebalancing: A Balanced Approach

Back to Finance Tips

After a few weeks of exploration, I’m going to bring it back to _It Can Be Easily Done_’s bread and butter: actionable personal finance tips to help you master your mental game of finance. This one is about portfolio rebalancing and it’s going to be short and sweet.

Strike the Right Balance

If you’re not familiar, rebalancing is the concept of choosing a target portfolio allocation (say 75% stocks and 25% bonds or 60% U.S. stocks and 40% international stocks or whatever portfolio strikes your fancy) and then making trades over the course of time to make sure that your portfolio stays at the target allocations. These trades usually come at a regular time interval (e.g. monthly) or when the actual portfolio allocation deviates from the target by more than some percentage.

Let’s see a quick example. You start with $100, 75% stocks and 25% bonds at the start of the year. Unfortunately, there is a stock market correction and the stock value drops by 20%. Assuming the bonds don’t change value, now you have $60 of stocks and $25 of bonds. Even though you didn’t buy anything new, your allocation is now ~70/30. If you sell around $4 of bonds and buy stocks, now you’re at $64 stock, $21 bonds, which is back to ~75/25.

That’s rebalancing. Why would you do it?

It encourages you to buy low and sell high. Above, you buy more stocks because they went down. If you believe that financial assets tend to revert to the mean, then rebalancing should help you capture that phenomenon.
It encourages you not to buy high and sell low. This is a tautology based on (1), but I want to highlight the psychological aspect here. Left to your own devices, might you want to pile in on stuff that’s gone up recently? Or sell something just because it went down a lot? In the long run, this is generally not a good reaction and disciplined rebalancing helps you avoid it.
It helps control your risk. If instead of going down by 20%, let’s say your stocks went up by 100%. That’s amazing luck, but now you’re at an 85/15 split of stocks to bonds. If you continue to let this happens, you’ll drift towards a very stock-heavy allocation. That could be fine if you mean to be investing very aggressively, but it is an unwarranted risk if it happens by accident.

So, it seems like rebalancing is great. It manages your risk and it seems to promise higher returns. Some would call this a free lunch. Can it really be that good?

Of course not.

Why might you not want to rebalance:

It costs money to trade. There are brokerage fees and stock spreads to worry about. Even more impactful are the tax implications of frequent trading. Many of these fees are avoidable (e.g. by trading ETFs in a Vanguard IRA brokerage account), but you need to take them into account before calling rebalancing a panacea.
Notice that all of the benefits above rely on mean reversion. If instead of what goes up must come down, some assets that are going up tend to continue going up then rebalancing won’t help you. You’ll just be taking money out of things that performed well to put them into things that perform poorly. It turns out that is a real problem that we’ll delve into below.
Rebalancing makes things more complex. This is “It Can Be Easily Done”—is rebalancing even worth doing?

In summary, I’ll boil the considerations down to two main points: 1) rebalancing is more about risk mitigation than it is about enhancing returns and 2) any return enhancement is based on mean reversion, which isn’t a sure thing.

Now let’s look at both points with an eye on how much complexity is warranted by considering two common approaches to rebalancing.

Problem 1: I’m Not Rebalancing At All

This is by far the most common rebalancing problem because it’s easier to not rebalance than to rebalance. However, if you took the time to determine what level or risk you’re willing to take on (and you should!), I’d argue that you should also maintain your portfolio balance to match your risk tolerance.

The risk you should take on is a function of your goals, time horizon, and current financial situation. It should not be overly influenced by how your portfolio is performing. This is especially important because left alone, your portfolio will drift towards a higher and higher stock allocation (and risk) over time when you likely want it to be doing the opposite.

And “it’s too hard” or “I forget to do it” isn’t an excuse. Want a diversified portfolio that automatically rebalances to a target stock/bond allocation? Vanguard’s LifeStrategy funds will do this for you. Pick an allocation and it will stick to it. Alternatively, if you want your allocation to become more conservative over time (rather than the default of becoming more risky), Vanguard (and most other fund companies that service 401(k)s) provide target retirement funds that do just that. The stock exposure goes down over time and the bonds come up. No work from you.

One quick note if you’ve read my post that recommends leveraged lifecycle investing is that you may not actually want any bond exposure early in your investing journey. Note that target retirement funds and the like won’t give you this sort of allocation path, nor will they allow leverage. If you’ve bought into the leveraged lifecycle concept, you’ll need to do your risk management and rebalancing on your own, at least for now. That said, if rebalancing regularly seems too hard, you have no business using leverage (even if it works!)…

If you want even more flexibility without extra effort, robo advisors like Betterment or Wealthfront offer automated portfolio rebalancing along with other services like automated tax loss harvesting. Heck, you could even pay a financial advisor to do the rebalancing, although I wouldn’t recommend paying that much unless they’re providing you more value than just rebalancing your portfolio!

To summarize, you should be rebalancing your portfolio occasionally (at least once every few years) to make sure that it matches your current risk tolerance. You can make this happen automatically for low cost if you stick to a traditional stock and bond allocation.

Problem 2: I Can’t Leave Well Enough Alone!

This next problem is less common, but it’s the one I have, so let’s talk about it. What if you love to futz around with your portfolio allocation? I know I do. Given that there are downsides to rebalancing (cost, complexity, potential loss of returns), how do you resist the temptation to do harm?

The trick here is to identify the correct rebalancing period and set up rules that give you something to do while still encouraging appropriate patience. Vanguard suggests rebalancing every 6 months to a year or when your allocation is off by more than 5%. Academic research indicates that optimal rebalancing periods based on risk-adjusted returns can be as long as 4 years!

If it’s so good to buy low and sell high, why is the interval so long? In short, it’s because in the short run, most financial assets demonstrate momentum. In the long run, they tend to demonstrate mean reversion. It turns out that momentum is most prominent in periods less than a year long and mean reversion in periods more than a year. The exact balance, which changes over time, is what dictates an optimal rebalancing period.

Said another way, if a stock is demonstrating momentum, what goes up tends to go up more. You don’t want to rebalance away from something that is still going up! Once it starts to mean revert and go down is exactly when you want to rebalance. Buy low, sell at the absolute highest point.

Of course, this is very hard to do in practice. No one knows exactly when a stock will stop going up and start reverting to the mean.

But… we can use this general insight to help us rebalance without overdoing it.

Here’s what I do:

Do rebalancing calculations every month for each asset.
Do a momentum calculation every month for each asset. I use a variation on absolute momentum, but any kind of reasonable trend following approach should work.
Only trade if I’m supposed to rebalance and I’m selling an asset with negative momentum or buying an asset with positive momentum.

The beauty of this strategy is that it not only attempts to take advantage of the balance point between momentum and mean reversion but it also encourages patient trading. Since I need to meet two conditions, it becomes much less likely that I make a trade. Even though I am checking every month (something to do!), I find that for a given asset, I’m generally only trading a few times a year, sometimes less. It’s not quite 4 years between rebalances, but the costs are significantly lower than they would be left to my own devices.

The potential return exposure to the momentum factor is just icing on the risk mitigation cake!

Conclusion

And with that, I’ll call it a day. Rebalancing your portfolio periodically is a meaningful risk mitigation best practice, but it’s not the panacea that some make it out to be. If you aren’t rebalancing at all, consider setting up some automation so that your risks don’t get out of whack. If you’re rebalancing more than twice a year, consider adding a momentum overlay to keep yourself from being too active.

I hope you found this article useful; if you did, please share it. I’m diving in more into finance as a special focus of It Can Be Easily Done based on your feedback. Keep it coming!