portfolio rebalancing strategy is the discipline behind successful portfolio
management. Deciding what investments to
buy is only part of managing an investment portfolio. All asset markets fluctuate, and watching
your investments gyrate up and down can become nerve-wracking, to say the
least! You’ve got to have a long-term
plan so that you can ignore the markets and keep your portfolio on track with
some peace-of-mind. This is why you NEED
a specific strategy — it will guide your investment decisions when the
economy and/or stock market are going wonky.
should be made by reason, not emotion.
Every successful investing strategy requires some self-discipline. You’ve got to ignore the distractions of the
media and others’ advice, and stick with your plan.
Sticking with your
plan is easier when:
it doesn’t eat up too much of
it doesn’t require quick
you know a loss won’t wipe you
it doesn’t require large
commitments of capital
you’re in it for the long-haul
your asset allocation is the most significant decision you will make as an
investor, your rebalancing strategy is the self-discipline that will help keep
you in control of your portfolio.
The primary function
of portfolio rebalancing is to control risk.
Different asset classes perform differently over time, causing your
portfolio to drift away from your target asset allocations. Over time, some of your assets will
outperform, while others under-perform during a particular market cycle. Rebalancing controls your risk by moving
capital between these outperforming and under-performing assets.
boosts return. When you rebalance, you
take gains from your out-performers (selling high) and redeploy that money into
your under-performers (buying low).
Sell-high/buy-low is a hallmark of disciplined investing. When the market turns, and it will, you’ll
have taken gains when you had the chance, and will be loaded up on asset
classes set to go up under new market conditions. Even though it will very likely take some
temporary hits along the way, your overall portfolio will trend upwards.
note: this information will only make
sense if you’ve already read the information on Investment Portfolio Management
and Allocation Ratios.)
rebalancing at a pre-determined time-frame. Quarterly or annually is common, and allows
you to remain mostly hands-off with your portfolio. Rebalancing more often doesn’t necessarily
improve the performance of your portfolio, and the extra transaction fees must be considered. However, rebalancing more often may be
prudent if your portfolio is aggressive and, therefore, more volatile than a
more conservative portfolio. For individual stocks, use a trailing stop for each
stock you own, rather than a rebalancing strategy.
Threshold-based: rebalancing when an asset class grows to a
pre-determined threshold above its target size. Let’s say you own an ETF of small-cap stocks, which you have determined will hold 10% of your portfolio, and this fund grows to be 5%
larger than its 10% target. (If your portfolio is worth $50,000, this target would be $5,000, and you would sell some off the top when it reaches $5250.) Sell the gains
to bring your position-size in line with your target, and redeploy that capital
into, say, a bond fund that is about 5% below its target.
a simple way to rebalance is to put new money and dividends into
underweight asset classes. While this
doesn’t address overweight classes in your portfolio, it does bring your
overall portfolio size up (depending on how much you’re adding), affecting
whether or not an overweight asset class remains overweight as a percentage of
the whole. What it does do is easily
bring your underweight classes nearer their targets with (ideally) one simple
is a fairly simple, yet productive, process.
The enemies to following through are psychological: during bull markets, investors tend to want
to stay in (taking on more risk) rather than taking money off the table; during
a bear market, investors become risk-averse, fearing putting more money into
“losing” asset classes.
Developing the mindset that nice gains won’t last (so
sell-while-you-have-the-chance) will reduce your risk of loss when the market
turns (and it will). Seeing assets that
have declined as being “on sale” (get-it-while-its-hot) will position
you for better returns when the market turns again (and it will). Keep in mind, we’re talking about asset classes here, not individual
securities. (Always do your due
diligence before purchasing any stock!)
College graduates and
other 20-somethings are the most likely to fall into the trap of not
rebalancing regularly, simply because their investable capital is small, and
any decline is more acutely felt. The
short-term volatility of rebalancing in a down market will easily fray the
nerves of the new investor, but the long-term benefits outweigh this negative
factor, especially for young investors with a long time horizon. Portfolio rebalancing not only boosts returns
in the long run, but it also teaches the young investor discipline, the
importance of asset allocation, and how to stick with their plan.
If you are
risk-averse, rebalance annually, and check your portfolio as infrequently as
If you’re more
hands-on with your portfolio, rebalance quarterly with a 5% threshold. At the end of each quarter, calculate your
asset allocations as a percentage of your total portfolio. If any allocation has drifted away from its
target by 5% or more, rebalance your portfolio.
If you are still
regularly adding new money to your portfolio, use the new money to adjust your
position sizes according to your targets.
This helps you in rebalancing your asset allocations and is very tax
Remember: because of transaction costs, taxes, and just
plain old psychology, it is always wise to minimize the frequency of portfolio rebalancing, but don’t neglect it altogether. Figure out which method
will likely work best for you and your situation, and stick with it!
NOTE: the one time rebalancing could potentially
ruin your portfolio is if the market is in a very long-term downtrend (i.e.
Japan). There is no way to foresee this
ahead of time, but maintaining a sizable position in cash at all times will
help reduce loss, as well as position you to deploy some capital when things
turn around and opportunities abound once again.
Good investing, faithful steward!