What is Portfolio Rebalancing?
Portfolio rebalancing is the systematic process of periodically realigning an investment portfolio’s actual allocations with the allocation percentages that were originally planned. This is accomplished by reducing positions that have become an outsized percentage of the portfolio (due to relative outperformance) or increasing positions that make up a lesser-than ideal percentage of total holdings (due to relative underperformance).
Why is this done? Typically, it’s done to ensure the portfolio matches an investors risk tolerance, time horizon, and goals.
Some things to consider when rebalancing:
- Rebalancing can Potentially Increase or Decrease Portfolio Performance
- What is the Optimal Rebalancing Frequency?
- Taxes Implications
- Monitoring Challenges
- Changes in Goals and Risk Tolerance
The two most commonly used rebalancing policies are based on:
- Frequency (quarterly or annual rebalancing), or
- Portfolio drift (rebalancing only when allocations move beyond a certain threshold relative to target levels).
So which strategy is best for managing risk and maximizing performance?
A research platform I use within my own financial planning business has recently done a deep dive into this particularly important question that I thought was interesting.
The research was conducted using 6 different rebalancing strategies, each beginning with a broad based 60% equity (stock) and 40% fixed income (bond) portfolio.
- Monthly Rebalancing
- Quarterly Rebalancing
- Annual Rebalancing
- 5% Drift Rebalance
- 10% Drift Rebalance
- Never Rebalance
Each of the 6 portfolio rebalancing strategies was studied over a 25 year period, the analysis looked at performance and volatility.
This 25 year period includes four bull markets and three bear markets. The findings show the pros and cons of different rebalancing policies and may inform your own best practices for portfolio management.
Some of the questions that were answered are:
- How Rebalance Frequency Affects Performance
- How Rebalance Frequency Affects Risk Management
- Should You Rebalance Differently During Bull and Bear Markets?
- Costs of Rebalancing: Transactions, Time, and Taxes
Key Findings
- On a cumulative basis, rebalancing strategies that rely on the triggering of drift thresholds and portfolios that never rebalance outperform those with rebalancing strategies based on calendar frequencies.
- While more frequent rebalancing keeps actual portfolio allocations more in-line with target allocations, the risk-management benefits diminish when a portfolio is rebalanced too frequently.
- The optimal rebalancing strategy fluctuates based on bullish and bearish market conditions, with considerable consequences.
- Investors must factor in the hard costs of rebalancing, such as time and labor, and taxes when deciding on the best strategy for them and their clients.
Conclusion
On a cumulative basis, rebalancing strategies that rely on the triggering of drift thresholds outperform those with rebalancing strategies based on calendar frequencies. And while portfolios that never rebalance do perform relatively well over time, such a strategy can miss out on secular growth if only a small percentage is allocated to asset classes that eventually become market leaders, even if only temporarily. While more frequent rebalancing keeps actual portfolio allocations more in line with target allocations, the risk-management benefits diminish when a portfolio is rebalanced too frequently.
The optimal rebalancing strategy for managing risk, maximizing performance, and minimizing costs will change over time, based in part on market conditions. However, more important than any of these factors is your comfort level with the chosen rebalancing strategy and your comprehensive financial plan.
As is often said, “peace of mind can be priceless.”
-Paul R. Rossi, CFA