Rebalancing plays a crucial role in portfolio management, both to ensure that the overall risk of a portfolio doesn’t drift higher (since risky investments can out-compound conservative ones in the long run), and to potentially take advantage of sell-high, buy-low opportunities. But it’s not entirely clear how often a portfolio should be rebalanced to meet these goals.
The conventional wisdom is to rebalance at least once per year, and possibly even more frequently. But more frequent rebalancing on average has little impact on risk reduction, even less benefit from a return perspective, and just racks up unnecessary transaction costs along the way.
Research suggests a superior rebalancing methodology is to allow portfolio allocations to drift slightly, and trigger a rebalancing trade only if a target threshold is reached. If the investments grow in line and the relative weightings don’t change, no rebalancing trade occurs. However, if these “rebalancing tolerance bands” are breached, the investment—and only the investment—that crosses the line is then bought or sold to bring it back within the bands.
This, however, requires ongoing active monitoring of the portfolio so you know when a threshold has been reached. Fortunately, a growing number of rebalancing software tools are available to help advisors track each investment and its rebalancing thresholds, and even to automatically calculate and queue up the rebalancing trades necessary to bring the portfolio in line again.
Optimal Rebalancing Time Intervals
In the long term, rebalancing serves an important function in keeping a portfolio targeted to the appropriate level of risk, since otherwise higher-risk investments that have higher long-term returns would become overweight by outperforming the lower-risk, lower-return investments.
In the short term, though, rebalancing presents the opportunity to generate better returns, because selling what’s overweight and buying what’s underweight typically is the same as selling high and buying low. In essence, the goal is to find investments that have moved to extremes, and trigger a rebalancing trade that buys/sells the investment just before it “snaps back” and reverts to its long-term average. If the investments are never rebalanced before the snapback occurs, the opportunity is lost.
Still, rebalancing can be done too frequently. For instance, if an investment is about to go on a huge run of outperformance for the year, rebalancing monthly would trigger a significant number of sales before the year’s gains have occurred, and thus the investor has missed a lot of the upside. Similarly, if an investment is about to decline in a yearlong crash, rebalancing monthly will have the investor repeatedly buying into a decline.
Very frequent rebalancing can also grind down its own long-term benefits as the transaction costs mount. The rule, then, is “often enough, but not too often.”
Which raises the question: How often?
Monthly rebalancing would appear to be too frequent. What about quarterly? Annually? How often do asset class returns shift their direction, and how would an investor optimize the timing of the rebalance?
Unfortunately, even with relatively “simple” asset classes like stocks and bonds the timing of market cycles is not consistent. It would be easier if bull markets always lasted the same amount of time—five years, for instance. But that’s not the case. Some bull markets are long with few or no corrections, while others are more volatile or shorter.
And bear markets tend to occur more quickly, so the optimal bear-market rebalancing cycle may be different.
Furthermore, as the number of asset classes expands, so too does the number of potential investment cycles to optimize, and they will virtually never be fully in sync with one another.
A study by Vanguard basically found no material differences in outcomes for rebalancing frequencies varying from monthly to annually, when they were measured over rolling periods. Using a 60/40 portfolio going back to 1926, the researchers found that rebalancing quarterly or monthly produced no improvement in the long-term risk or returns; it simply drove up the turnover rate and the number of rebalancing events (and potential transaction costs).
Allocating With Tolerance Bands
Conceptually, the goal of rebalancing is to sell an investment after it has fully (or at least mostly) had its favorable run, and similarly to buy an investment after it has fully (or at least mostly) declined. Yet as noted, because a diversified portfolio has a wide range of investments, which do not necessarily peak and trough over the same intervals, it’s difficult to find an optimal rebalancing frequency.
An alternative, however, is to change the process, rebalancing not on a time table, but according to how “out of whack” an investment or an asset allocation has become.
For instance, a portfolio targeted at 50% equities and 50% bonds might rebalance whenever the total equity exposure grows above 60% (a threshold signaling a significant outperformance of stocks over bonds, implying that they might have become overvalued).
It doesn’t matter if it takes six months or three years, the rebalancing wouldn’t occur until the equities reached the 60% threshold. This ensures that the stocks are not sold “too early” while they’re still rising.
Conversely, there would be a “buy” trigger if equities were to decline—say, if the equity exposure started at 50% but fell below 40% in a bear market. The purchase, again, depends on the threshold—and doesn’t happen until the stock weighting passes under the 40% mark, whether that takes six months or 24 months (even during a bear market).
Thus, with “allocation tolerance bands,” a portfolio targeting 50% in equity exposure would now trigger a rebalancing trade if the equity allocation fell below 40%, or above 60%. Anywhere in between those thresholds and the portfolio simply remains a buy-and-hold strategy.
It is important to note that the allocation bands are based not on dollar amounts nor appreciation but only on portfolio allocation percentages. The distinction is important, because investors shouldn’t be rebalancing simply because investments decline or appreciate in value. In a portfolio where everything is up by 15%, the weightings would be the same, and no rebalancing trade should occur. In other words, it’s not favorable investment performance but relative outperformance that should trigger a rebalancing trade.
That approach in a portfolio with multiple asset classes will also help to reduce the volume of rebalancing trades (and therefore save on transaction costs). For instance, if there are five investments in the portfolio and only one of them dramatically outperforms—enough to reach the threshold and become overweight—only that investment will be sold and rebalanced. An investor, on the other hand, who simply rebalances every investment in the portfolio annually—even if it only needed a 0.1% trade—would be accruing wasteful transaction costs.