How to invest: Portfolio Rebalancing: How To Do It Right

Portfolio Rebalancing: How To Do It Right

Right about now, your broker or mutual-fund firm is sending you a note suggesting that midyear is a good time to rebalance your portfolio. But are they right? Maybe.

There should be a method to the practice of rebalancing based not on time markers alone or triggers alone, but on a combination of time markers and threshold targets, according to a series of studies produced by Vanguard Center for Investment Counseling & Research.

In a soon-to-be released study, Vanguard examined the three major rebalancing strategies--time-only, threshold-only and time-and-threshold--and found that the time-and-threshold strategy makes the most sense. They say it's best to review your portfolio every six or 12 months and then rebalance if your target asset allocation is off-kilter according to some predetermined threshold, say five percentage points or more.

How did Vanguard come to that conclusion? Well, before we tell you that story, we have to tell you another one. According to Maria Bruno, an investment analyst with Vanguard's Investment Strategy Group, the first order of business is to have an asset allocation--the percent you should invest in stocks, bonds, and cash based on your investment policy statement.

If you don't have an asset allocation, now is a good time to create one. If you do have an asset allocation, now is a good time revisit the purpose of rebalancing, which investors don't always get right.

"The primary goal of rebalancing is to minimize risk relative to a target asset allocation, not to maximize return," Bruno said, in an interview. In other words, it's about reducing the volatility of the portfolio, not generating the highest return.

Never Rebalance?

Vanguard examined the performance of a classic 60% stocks and 40% bonds portfolio from 1929 through 2009 using a variety of rebalancing strategies, including a "never rebalance" strategy.

In one case, it examined the performance, volatility and costs associated with a 60/40 portfolio that was rebalanced monthly versus a portfolio that was never rebalanced.

The performance of those two portfolios was similar, but the volatility was very different. The never-rebalanced portfolio earned on average 9.1% per year from 1929 through 2009; the monthly-rebalanced fund rose by 8.5%.

But the never-rebalanced fund was 20% more risky, having a standard deviation of 14.4 versus 12.1 for the rebalanced-monthly portfolio, according to Vanguard's study. Viewed another way, the percent invested in stocks in the never-rebalanced portfolio by 2009 was 98% versus 61% for the other portfolio studied.

Time-Only Strategy

Obviously, never rebalancing doesn't work. Using the time-only rebalancing strategy, be it monthly, quarterly, every six months or every year doesn't affect performance nor volatility in a material way. But the costs associated with rebalancing--in terms of taxes, commissions, and time and labor--do change dramatically.

Threshold-Only Strategy

The "threshold-only" rebalancing, meanwhile, ignores the time aspect of rebalancing. According to Vanguard, investors following this strategy would rebalance only when the portfolio's asset allocation has drifted from the target allocation by a predetermined minimum rebalancing threshold such as one percentage point, five percentage points, or 10 percentage points, regardless of the frequency.

It's quite possible that a portfolio could be rebalanced as frequently as daily or as infrequently as every five years using this strategy, Vanguard said in its study.

Vanguard studied the effects of rebalancing using various thresholds--1%, 5%, and 10%--and found in the case of daily monitoring that no matter the threshold, each portfolio rose on average about 9%. What's more, the volatility was the same. The costs, however, were very different; it's far more costly to rebalance daily for instance when the threshold is set at 1% versus 5% or 10%.

Time-And-Threshold

Given all the possible strategies, and all the costs and benefits associated with those strategies, Vanguard concluded the following: "For most broadly diversified stock and bond fund portfolios, annual or semiannual monitoring, with rebalancing at 5% thresholds, produces an acceptable balance between risk control and cost minimization."

Of course, all this does prompt the question: What's the best way to rebalance? For her part, Bruno suggests that rebalancing is counterintuitive. "It means that you are giving up on your winners and going into your losers," she said. "And it's tough to do."

But if you consider that rebalancing is not about returns but about reducing volatility, it might make the process more palatable. "You won't gain returns, but you will smooth out volatility," she said.

In addition, rebalancing becomes a bit more complicated when you factor in the possibility of owning target-date retirement funds, or the possibility of having taxable and tax-deferred accounts. But those emotions and complications aside, Vanguard said, this rebalancing strategy, to the extent possible, "should be carried out by appropriately redirecting interest income, dividends, new contributions, and withdrawals."

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