Monday, September 19, 2011

Portfolio Rebalancing

Let’s say that late last April (2011) you decided that an appropriate asset allocation for you, based on your risk tolerance, was 50% stocks and 50% bonds, and that you preferred a very simple portfolio using only 2 asset classes: US Stocks and US Bonds. So, on May 2, you invested $20,000 by buying $10,000 of Vanguard Total Stock Market Index fund and $10,000 of Vanguard Total Bond Market Index fund. About three months later, on August 8, the stock fund had declined in value to about $8,150, the bond fund had increased in value to about $10,380 (assuming reinvested dividends), and your total portfolio was worth about $18,530 (data from At that point your portfolio was 44% stocks and 56% bonds; i.e., each asset class was about 6 percentage points away from it’s target allocation of 50%.

Assuming no changes in your risk tolerance or other factors affecting your desired asset allocation, you would have been wise to consider rebalancing your portfolio back to its target asset allocation of 50% stocks and 50% bonds. This could have been done by exchanging an appropriate amount from the bond fund to the stock fund (exchanging is a way to simultaneously sell shares of one fund and buy the same dollar amount of shares of another fund). With a portfolio value of $18,530, you would have wanted $9,265 in each fund, so you would have exchanged $1,115 from the bond fund to the stock fund.

Rebalancing is a risk management technique. If you have decided that having 50% of your portfolio in stocks is an appropriate level of risk for you, it’s not rational to allow changes in market values to significantly change your risk profile. It’s more rational to rebalance your portfolio to its target allocations, even though it may be emotionally difficult (because you are buying recent losers and selling recent winners). To be a disciplined investor, you must sometimes do what is emotionally difficult. To help with the emotions, consider that when you rebalance, you are buying the recent losers “on sale”.

There are three standard rebalancing strategies:

  • Rebalance at fixed time intervals (e.g., every 3, 6 or 12 months).
  • Use rebalancing trigger bands (i.e., rebalance if an asset class deviates by more than a predetermined amount above or below its target value).
  • Add new cash to the asset classes that are below target. With this approach, “new cash” could include dividends and interest from existing funds; e.g., rather than reinvesting dividends in the fund paying the dividends, have the dividends paid to a money market fund, then periodically use this cash to rebalance.

Many people rebalance at fixed intervals because it’s simple. Some 401(k) plans even let you set up automatic rebalancing at designated intervals (e.g., annually or quarterly). Using this approach, you only have to check your portfolio at the predetermined intervals (e.g., annually), or not at all if you have an automatic rebalancing option.

Using rebalancing trigger bands requires paying more attention to your portfolio, since you must check more often to see if any of your asset classes have exceeded their rebalancing thresholds. A typical rebalancing threshold is five percentage points above or below the target percentage for the asset class. Of course you can combine the periodic and rebalancing band methods; e.g., check your portfolio every 3 months, and only rebalance if a rebalancing threshold has been exceeded.

Adding new cash to the asset classes that are below target also requires monitoring your portfolio more often. For example, rather than directing 401(k) contributions to several mutual funds in fixed percentages, you would need to vary the contribution percentages with each contribution, directing more to the funds that have underperformed since your last contribution. Alternatively, you could make all automatic contributions to a money market fund, and then periodically (e.g., every 3 months) move cash from the money market fund into the stock and bond funds that are below their target allocations.

In the example at the beginning of this post, I illustrated rebalancing with only two asset classes, US stocks and bonds, but the same rebalancing strategies apply to a portfolio with additional asset classes. For example, you may decide to diversify your stock allocation between US and foreign companies, let’s say 70% US and 30% foreign. If one of these asset classes significantly outperforms the other, then you would rebalance the stock portion of your portfolio back to its 70%/30% targets.

If you decide to implement a more complex portfolio with even more asset classes, such as small-cap value stocks, REITs, etc., you would extend your rebalancing approach to these asset classes as well.

I have to admit that I’m not as methodical as some when it comes to rebalancing, but I do tend to do some rebalancing from fixed income (bonds and cash) to stocks after stock market declines of 10% to 20%, and perhaps rebalance from stocks to fixed income after stock market increases of 25% or more. I also force myself to add to my stock funds when it feels scary to do so (as Warren Buffet recommends), like on August 8 (2011) when stocks declined 5% or more, and on several other days in August when there were significant stock market declines. These large single-day declines occurred after stocks were already down about 10%-15% since early May, so I felt sufficiently motivated to do some exchanges from money market and bond funds into stock funds, even though my overall stock allocation was only 2 or 3 percentage points below its target level.

I pay the most attention to my allocation between stocks and fixed income (bonds and cash), since this has the most impact on risk. However, after the recent stock declines, my foreign stock allocation was below it's target relative to US stocks, so I added more to my international stock funds than to my US stock funds, to bring my US/foreign stock allocation closer to my targets of 60% US, 40% foreign. Also, small-cap stocks dropped more than the broad US stock market, so I added more to my small-cap and small-cap value stock funds than to my total stock market fund.

Although the primary purpose of rebalancing is to manage risk, it sometimes can result in higher returns, especially in volatile markets; this is sometimes referred to as the rebalancing bonus. If an asset class drops a lot and you buy more, then it increases a lot and you sell some, you’re going to make a little extra money. However, rebalancing can reduce returns if an asset class trends up or down for a long time, since you will be periodically selling assets that are continuing to go up, and buying assets that are continuing to go down, thus decreasing your return as long as the trend continues. For example, you would have had higher returns in the 1980s and 1990s by not rebalancing from stocks to bonds, since stocks had a great run during those years. Of course, when the tide turned and stocks dropped a lot, the portfolios of investors who had rebalanced declined less in value than those who had not rebalanced. Since rebalancing can sometimes help performance and sometimes hurt, and we can’t predict when either will occur, it’s probably best to focus more on the risk management benefit than a potential rebalancing bonus.

If you want to read some technical articles about rebalancing, here are links to a couple of Vanguard research papers on the topic:

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