When to Rebalance an Investment Portfolio

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Following Content Also Features as a Guest Blog Post from Loonie Doctor.

Rebalancing the investments in a portfolio helps to manage risk in the portfolio over time. A systematic approach to rebalancing also encourages disciplined investing rather than emotion-driven portfolio adjustments. This post explores the mechanics of how frequently to do it and how aggressively.

When should I rebalance my portfolio?

As humans, we are innately attracted to market-timing (attempting to “buy low and sell high” thinking that we may know where the market will head next). It is hard-wired into our psyche to try to recognize patterns to predict future events. Unfortunately, the future is unpredictable. This is coupled with the powerful emotions of greed and fear. These may have been helpful from an evolutionary basis, but they can fuel poor investor performance.

The act of rebalancing a portfolio, in practice, involves buying and selling investments. The more that we can link that to an objective trigger instead of our intuition and emotions, the better. The trigger to rebalance a portfolio is usually either time or an event.

Time as a rebalancing trigger.

A time trigger uses a set date to rebalance. That could be annually, quarterly, or monthly. No specific frequency has been definitively shown to produce better returns or volatility reduction than another. For example, Vanguard compared monthly, quarterly, annually, and never rebalancing over an 80 year period. Their results are summarized in the table below.

More frequent rebalancing resulted in a tighter tracking to the desired asset allocation. It also reduced the annualized return slightly in exchange for reducing the volatility. This is the expected result of rebalancing. Some theoretical investment return is given up to hopefully have a better real-life return. The real-life return would presumably be improved by reducing the performance gap from bad investor behavior.

The main benefit was seen from annual rebalancing. More frequent rebalancing did not reduce volatility further. In fact, frequent rebalancing comes at a cost.

With each rebalancing event, there would be buying and selling. More frequent buying and selling increases the transaction costs from brokerage fees and the bid-ask spread. If there are capital gains realized in a tax-exposed account, then there would also be more tax drag. These worsen actual after-tax performance. The effects of rebalancing frequency on transactions in the Vanguard model are shown below.

Importantly, rebalancing a portfolio also takes time. That may be a good thing for investors who feel compelled to tinker with their portfolio in some way. For most of us, less time spent tending to our investments is better.

Thresholds as a rebalancing trigger.

Since rebalancing frequently is not helpful, and may even trigger fees or taxes, using a threshold is another approach. Using a time-based strategy, you would be buying and possibly selling at the designated time even if your asset allocation is only off by 1%. Probably not worth it!

Perhaps you would be willing to accept some drifting under and over your planned allocation. The risk may fluctuate slightly more, but you would avoid unnecessary transactions. This is where a threshold trigger fits in.

A commonly suggested threshold to trigger a rebalance is if an asset allocation is off by 5% absolute (relative to the portfolio) or 25% relative to itself. The 5/25 rule. That threshold could be breached in either direction with an asset being too high or too low compared to its target.

How does the 5/25 rule work?

For example, if my Canadian equity target allocation is 10% and it currently sits at 13%. The 3% difference falls under the 5% absolute target. So, that does not trigger a rebalance. However, it is over the 25% relative-to-itself target (1.25 times 10% equals 12.5%) and that does trigger the rebalance. A rebalance is triggered if either of the 5% or 25% threshold is breached.

Which threshold of the 5/25 rule gets breached depends on how large the asset allocation is. Larger allocations tend to breach the absolute threshold first. For example, if our bonds allocation is 40% and currently sits at 46%. The 25% relative threshold would be 1.25 times 40% equals 50%. The 46% bonds does not breach the 25% relative threshold (it is under 50%). However, 6% is greater than the 5% absolute threshold – that triggers a rebalance.

I know. Confusing. Below is a theoretical portfolio below and I have highlighted where the 5 or 25 of the 5/25 rule has been triggered.

How does the 5/25 rule perform compared to other thresholds?

As outlined in the preceding post, that would depend partly on the time-frame used and whether the assets were in trending or choppy markets. Rates of return and correlation of the different assets in relation to each other also have an impact. Attempting to tackle that for a multi-asset portfolio would cause my brain to explode. Messy. Most readers would tune out or be grossed out. Let’s not go there.

However, I have a hard time accepting “rules of thumb” without testing them. So, let’s look at different absolute thresholds using a very simple portfolio of US Large Cap (Stocks) and Intermediate-Term US Treasuries (bonds). A daily closing price above the threshold triggered a rebalance.

threshold performance

Moving from a 1% to a 5% threshold cuts down on the number of transactions dramatically. The overall effects on return were minimal regardless of the threshold used. Volatility gradually increased with increasingly loose thresholds by a minuscule amount. So, it seems that the 5% part of the 5/25 rule held up well over this time period. You could probably even go a little looser up to 10 or 15%.

In the appendix of the Vanguard study already referenced, the results were similar over a shorter time period (1989-2009). They also did not find a difference in whether you monitored for threshold breeches daily, monthly, quarterly, or annually. Returns and volatility were similar, but transactions increased with more frequent monitoring.

A Pragmatic Approach To Triggering a Rebalance

The above data shows that there is no need to rebalance more frequently than once per year. Most people contribute or withdraw from their portfolios at least once a year. So, it makes sense to do a rebalance if you are making a contribution or withdrawal. This is sometimes called a “cashflow triggered” approach. You rebalance when you have the cash to invest, or you need to access it.

During the accumulation phase of our investing, that basically means rebalancing whenever you have enough excess money that you don’t need in the short-term to invest it for the long-term. Aggressively “investing” money that you will need in the near term is really gambling.

How much accumulated cash is “enough” to trigger a contribution is variable. A question of fees, cash flow, and convenience.

For someone making small contributions and paying transaction fees.

There is a balance between waiting and missing time in the market against having a larger proportion of the contribution go to fees. An investor using $100 to buy an ETF with a $5 brokerage fee loses 5% of their money right off the top. For investors making small contributions, an online broker with free ETF purchases can help that problem.

Many high-income professionals make large contributions, making the fees a negligible issue. Cash flow and convenience are the main determinant.

An employee collecting a regular paycheck will often use automated contributions for both convenience and dollar-cost-averaging. Automation also minimizes the potential for bad behavior. However, investing upfront whenever you have the money has a slight advantage over monthly dollar cost averaging in the long-run.

For many professionals and business owners, money comes in fits and spurts. That is a result of variable revenue, but also large movements of money to pay personal and corporate tax installments.

What do we do personally? We use cash flow for timing and a threshold as our trigger for action.

We stockpile enough money and have enough certainty that we won’t imminently need it about four times per year:

  • January: Front-loading our RESP, TFSAs, RRSP, and spousal RRSP
  • April: We invest the excess, after settling our personal income taxes.
  • September/October: We have accrued some money and know where we stand after our corporate taxes are settled. Our corporate fiscal year ends July 31st.
  • December: A combination of cleaning up our budget, paying our final quarterly personal tax installment, tax loss selling (if the opportunity), and planning for the next year.

In addition to cash flow limiting us to about four rebalances per year, I don’t really want to spend time doing it more frequently than that. I have better things to do.

Incorporating a threshold trigger component.

Even though we are rebalancing quarterly when we have cash, that does not necessarily mean that we rebalance to perfection. We accept up to a 5% drift above the assigned allocation for our assets. I am too lazy to use a relative trigger and it does not add much for us. The 25% relative trigger can be useful for those with multiple holding/assets with small allocations of under 10-15% each.

In practice, this means that most of our rebalancing is simply adding our new contributions to an area that is lagging. However, as the portfolio becomes large relative to the size of the contributions, some selling may be needed to come back into the target range. Last year, we had to sell some of our US equity during our early fall rebalance. Fortunately, we were able to offset that with some tax-loss selling a couple of months later.

Rebalancing is important. However, it does not need to be frequent and it must be simple enough to execute.

Rebalancing investments can be very simple for those using a single account type or holding the same asset allocation in each account rather than trying to optimize asset location. Rebalancing within an account during the “buy-only” accumulation phase can even be semi-automated with a service like Get Passiv. An asset allocation ETF can also make it easy for those who want a simple pre-made solution at the slight cost of fees and some tax inefficiency in tax-exposed accounts.

Those facing a larger tax burden, using multiple account types, or with a large portfolio may need to consider rebalancing across account types. That can be a bit more complex. Still, it needs to be simple enough to easily execute. We’ll look into how to do that further in the next post i this series.

Blog Post Excerpt from Loonie Doctor.

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