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How and When to Rebalance your Portfolio


Previously we discussed how to set your asset allocations and where to invest. The problem with setting your asset allocations is that over time the classes will have a different performance. This means that over time they will shift away from your chosen allocation. At some point you will want to bring the percentages back in line, this is when you should Rebalance your portfolio.

The Risks of Rebalancing

The problem with rebalancing is it can be very costly. Each transaction you take in your account likely has a fee. It could be $8 dollars per trade as is per common for the big online brokerages, it could be a load fee on a mutual fund, it could be a short term trading fee on a index fund, or it could be the spread on a stock or ETF. Constantly rebalancing to keep yourself mixed as desired will result in huge fees and is likely not reasonable. Furthermore, if you’re constantly rebalancing you will miss out on some of the momentum of the market within different asset classes. For example, if stocks make 6% and bonds 3% on average over the long run, then by constantly rebalancing you’re reducing your overall gains.

Finally, rebalancing without a plan can ultimately amount to market timing. If you’re not following some logic when deciding to rebalance your portfolio then you will be more prone to do so based on what is going on in the market. As stated previously, market timing is not effective, especially for individuals.

When to Rebalance your Portfolio

So, based on the above it’s obvious you need to create a rebalancing plan and stick to it if you want to be effective. This will avoid you shifting into the realm of market timing or costing yourself huge trading fees. That plan should define under what conditions you rebalance your portfolio and how you do so.

So the first step is to determine when you will start executing rebalancing. Traditionally, there are 3 ways to do so. The first is to determine a threshold of allocation shift under which you will begin to rebalance. You don’t want this number to be too low or you will capture all the problems with the risk of rebalancing. If I were using this methodology I would prefer 5% for this value. The reason is it’s not uncommon for the market to shift 2% in a few days. You don’t want a normal event to trigger a rebalancing. As such you want the percent set to a level where it won’t trigger except over longer stretches of time or during significant moves in the market. A second traditional way is to rebalance on a schedule, monthly, quarterly or annually. You would simply adjust the amount back into alignment at these points. The third is to use a combination of the two. The benefit here would be to avoid rebalancing for minute differences via the schedule version or rebalancing a significant number of times during a market downturn via the allocation shift method. As you’ll see later in this article there is a fourth, less traditional way, which I personally use.

Traditionally How to Rebalance your Portfolio

Typically when you rebalance you simply sell off a portion of the overweight asset equal to the balance issue and shift it to the underweight asset. So imagine stocks are now 10% higher then your planned allocation and bonds are 10% less. You would sell the 10% and stocks and buy 10% more in bonds. These traditional rebalancing techniques have come in for a bit of critique recently because of those risks I mentioned before.  Rebalancing is primarily an instrument to maintain values within your risk tolerance, not a way to outsize returns. As such I personally take a different approach to rebalancing then the traditional to further mitigate these risks. After all your risk tolerance is personal.

How I Rebalance my Portfolio

Let me start by saying my methodology won’t work for everyone. It works for those where their savings rate is significant compared to the amount of asset shift. If you’ve reached a point where your savings rate has tapered off for retirement you might be better off with the traditional plan. I am not retired and do not plan to be any time soon. As such when I go to rebalance instead of selling the overweight asset I adjust my new investments to favor the overweight asset. If I begin to see a sustained shift of 5% off the normal allocations then I begin to reduce my contributions to the overweight asset. This does result in a few months to a year of time before the rebalance completes, but it avoids all the rebalancing risks. Needless to say, this approach also requires a slightly larger risk tolerance then an immediate rebalancing. However, I’m willing to trade some level of added risk due to the slow adjustment back to my allocation in exchange for larger returns over time.

This methodology shouldn’t come as much of a shock to my regular readers. If you read my article a few weeks ago on our surprise income at the end of last year, you’ve seen a reference to me doing the same thing. In that case I put my money into my mortgage as a proxy for a bond. This actually shifted my portfolio from overweight stocks to slightly overweight safe investments. So my reaction was to drop safe new contributions to 0 for some time until I am again in balance. I could have also just used this money to rebalance perfectly, but if you read the article you know I had another goal driving the payment. In any case, it’s just another example of how I rebalance my portfolio.

For those who maintain a balanced portfolio, do you rebalance? If so how do you rebalance?

10 Comments

  1. Thanks for sharing your strategy on rebalancing your portfolio. Is there a certain threshold, in $, where a person should start to consider it? More specifically, I have $13k in my 401k. It probably doesn’t make sense for me to be toying around with the various percentages.

    I like your thoughts on putting money into other things rather than sell. That’s kind of my strategy

    • fulltimefinance@fulltimefinance.com
      [email protected] March 8, 2017

      13k might be a bit tough with most mutual funds selling in quantities of 1k. I’d probably consider my emergency account my bonds at that point and break the 401k across total stock market and perhaps a little international. I wouldn’t bother with bonds in your 401k until your portion of safe allocation is larger then your emergency account needs.

  2. MUSTARD SEED MONEY
    MUSTARD SEED MONEY March 8, 2017

    I also rebalance my portfolio at the 5% mark. It seems to work really well for me and I think it’s paired some of my gains and allowed me to make sure that my portfolio doesn’t get too out of whack.

  3. SomeRandomGuyOnline
    SomeRandomGuyOnline March 8, 2017

    I use the combination method of threshold and timing (annually). I try my best to perform any rebalancing in my tax-advantaged accounts to avoid capital gains taxes and/or brokerage fees.

    Thanks for the insight!

    • fulltimefinance@fulltimefinance.com
      [email protected] March 9, 2017

      Timing and threshold combined are a great way to avoid too much rebalancing churn. Doing it in your tax advantaged accounts is also a smart step if your trying to avoid the tax man. Thanks for stopping by.

  4. Smart Provisions
    Smart Provisions March 9, 2017

    I haven’t quite rebalanced my portfolio yet, but I think analyzing quarterly and making sure it’s adjusted to the correct ratio would be helpful.

    Thanks for the post, FTF. I’ll probably perform an analysis on my portfolio and do some rebalancing by the end of the month.

  5. Leo T. Ly @ isaved5k.com
    Leo T. Ly @ isaved5k.com March 9, 2017

    I normally rebalance my portfolio once a year and it’s usually towards the end of the year. I do this for two reasons. One, to pay less taxes as I sell losers to offset my gains. Two, I usually get a sizeable bonus at the end of the year so instead of selling overweight stocks I buy underweighted stocks to rebalance.

    • fulltimefinance@fulltimefinance.com
      [email protected] March 9, 2017

      Very similar to how I do it and a great idea to avoid capital gains, excess trading fees, and potentially missing additional upside.

  6. ReachingTheCrest
    ReachingTheCrest March 14, 2017

    I like the 5% rule suggested. I just adjusted my 401K two weeks ago because it had gotten out of balance.

    I’m much more of a set it and forget it guy when it comes to my brokerage after tax account. Maybe something i need to reconsider.

    nice post.

    • fulltimefinance@fulltimefinance.com
      [email protected] March 14, 2017

      It really depends on the size of that after tax account vis a vi the rest of your accounts. Your asset allocation should be across all accounts. Thanks for the added perspective.

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