The simplest way to rebalance your portfolio

What’s the right way to rebalance a portfolio is a question often asked and about as simple to answer as what’s the right way to end a relationship – the results vary according to circumstance and personal style.

A number of different portfolio rebalancing methods exist, but there’s no clear-cut evidence that there is one system to rule them all.

Research by the respected fund shop Dimensional Fund Advisors concludes:

There is no easy one-size-fits-all rebalancing solution. Rebalancing decisions should be driven by the need to maintain an allocation with a risk and return profile appropriate for each investor.

The optimal rebalancing strategy will differ for each investor, depending on their unique sensitivities to deviations from the target allocation, transaction frequency, and tax costs.

When it comes to rebalancing, like so many things in life, it’s doing it that counts, not exactly how you do it.

Calendar rebalancing

So, as passive investors like to keep things simple, you can go easy on yourself and plump for the most straightforward option: Calendar rebalancing.

Calendar rebalancing in action

Just pick a date and your rebalancing frequency:

  • Quarterly
  • Semi-annually
  • Annually
  • Every 2-3 years

When the clock strikes, you review how far your current asset allocations have drifted from your target weightings. And then you take action:

  1. Sell the out-performers
  2. Buy the under-performers
  3. Do so in proportions that return your portfolio to its target allocations

This apparent act of madness is banking on mean-reversion; you aim to cash in on the shooting stars before they fall back to Earth, while potentially turning today’s dogs into tomorrow’s winners.

Beware! The more often you rebalance, the more likely you are to curtail the superior returns of the winners before they turn into losers – essentially because you cut the winning run short.

The advantage of frequent rebalancing is that you’re less likely to be over-exposed to an asset on the rampage, and so avoid excess pain when the sell-off begins.

Many finance professionals urge frequent rebalancing as a way of enhancing returns. But reliable evidence for this is scant, as it really depends on how you cut the stats to suit your argument.

The known cost of rebalancing

What is certain is that frequent rebalancing increases trading costs and potentially your tax liabilities. That can be more than enough to wipe out any chance of a rebalancing bonus.

I prefer to rebalance no more than once a year. That gives winning assets a reasonable time to go on a run, but also means I check in often enough to correct any major deviations caused by frothy markets.

Passive investing guru William Bernstein advises:

“Rebalance your portfolio approximately once every few years; more than once per year is probably too often. In taxable portfolios, do so even less frequently.”

The weakness of infrequent calendar rebalancing is that it can leave you exposed to big changes in your portfolio – occurring over short periods of time – when markets are volatile. The answer to that is threshold rebalancing.

Take it steady,

The Accumulator

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