Rebalance your Portfolio, But Not to Excess

Transaction costs, time horizon and personality all play a role when it comes to rebalancing your portfolio

Christine Benz 3 January, 2014 | 7:00AM
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Reams of academic data show that periodically rebalancing a portfolio back to its target allocations is one of the simplest ways to lower the risk of your investments without doing significant harm to your portfolio's return potential.

But how often should you rebalance? The answer is less clear-cut. On the one end of the spectrum are investors like David Swensen, manager of the Yale endowment, who rebalances the Yale portfolio every day. That's fine for big institutional investors such as those who manage university endowments in the United States, which don't pay taxes on their investment gains and pay razor-thin commissions on their trades. But frequent trading is apt to make less sense for smaller investors. Not only are trading costs likely to erode whatever investment benefit smaller investors might derive from frequent rebalancing, but such an active rebalancing plan also requires a sizable time commitment.

For that reason, I've long urged investors to take a hands-off approach to monitoring and rebalancing. After all, if you're checking in too often for asset-class shifts, you may also run into other tweaks you'd like to make, such as adding a little bit of extra cash to that manager who seems to be on fire or tipping some money into that new commodity exchange-traded fund you've been eyeing. A better approach, in my view, is to do a top-to-bottom portfolio review, including a check of asset allocation versus targets, just once or twice or year, then make changes only when your allocations to the major asset classes rise or fall 5 or 10 percentage points from your targets.

A Vanguard study adds some research rigour to that guidance. After looking at a variety of different rebalancing scenarios for a 60% stock/40% bond portfolio from 1926 to 2009--including rebalancing monthly, annually or quarterly and rebalancing when asset allocations hit certain thresholds--researchers Colleen Jaconetti, Francis Kinniry, and Yan Zilbering ultimately conclude that a hybrid approach represents a solid strategy for many investors.

Specifically, their work posits that monitoring a portfolio annually or semiannually, then rebalancing when the current asset-class weighting veers 5 percentage points from the targets, strikes the right balance between risk reduction and cost control. Not surprisingly, the portfolio that was never rebalanced had the highest level of return--as a result of its rising level of stocks in an 83-year period in which stocks beat bonds--but its volatility also was much higher than portfolios that were rebalanced periodically. Frequently rebalanced portfolios had the lowest risk without a big return give-up, but the costs of the frequent changes cut into returns.

Those guidelines are very useful, but finding the right frequency for your rebalancing programme is a personal decision that rests on a number of factors, including where you are in your investing life and the tax status of your investments. Here's an overview of what to bear in mind.

Tax Status of Your Investments

Rebalancing involves peeling back on your winners, which in turn could result in taxable capital gains if you're selling within your taxable accounts. That calls for erring on the side of less-frequent rebalancing if the bulk of your assets are in taxable accounts. (Those with a lot of assets in taxable accounts should also aim to take maximum advantage of tax-loss selling.) On the flip side, if you hold most of your money in tax-sheltered accounts such as ISAs, the tax costs of rebalancing aren't a concern. Ditto if you're rebalancing within taxable accounts but can afford to restore your portfolio to its asset-allocation targets by adding new money rather than selling.

Other Costs of Trading

Tax costs are just one component of the costs you might incur while rebalancing: Commissions are another. So if you use a commission-based broker or buy or sell your own stocks, investment trusts or ETFs on a commission-based platform, cost control argues for using a light touch when it comes to rebalancing. (It also calls for asking your broker some hard questions if he or she recommends more frequent asset-allocation adjustments than once or twice a year.) Those who do not use a broker, meanwhile, should view transaction costs as less of an impediment to rebalancing.

Time Commitment

It's stating the obvious, but a more frequent monitoring and rebalancing approach requires a greater chunk of time than a laissez-faire tack. If you're retired and have the time to commit to more frequent oversight--and won't incur tax and transaction costs to rebalance--it's okay to be more hands-on. Conversely, if you don't have time to give your portfolio any more than the periodic anxious thought, it's fine to check up annually and tolerate higher divergences with your target allocations.

Time Horizon/Risk Tolerance

The key benefit of rebalancing is in the realm of risk reduction, not in returns enhancement. By extension, it stands to reason that investors with shorter time horizons and more limited risk tolerance will want to tightly police their asset allocations versus their targets. Longer-term investors, meanwhile, can safely employ a more hands-off approach that involves rebalancing when allocations veer 5 percentage points (or even more) from their targets.

An earlier version of this article was originally published in August 2010.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Christine Benz

Christine Benz  is director of personal finance at Morningstar and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances.