Rebalancing: Whether, When, and How?

Buy, hold, and rebalance is dogma among strategic asset allocators. But do investors actually follow through on the rebalancing piece?

That was the question I sought to answer by posting in the Portfolio Design/Management forum of Morningstar.com's Discuss boards early last week. I asked Morningstar.com readers whether or not they actually rebalance. And among the rebalancers, I wanted to know how they do it. Do they rebalance at a specific time each calendar year, or do they do so only when their portfolios' allocations get out of sync with their targets?

Based on the ensuing thread, rebalancing clearly has its detractors, with some saying the practice has the potential to trim returns, jack up tax bills, and, at a minimum, trigger a headache or two. Most respondents said they tend to believe in the practice, but even they vary widely in their implementation. Some are quite hands-off and laissez faire, while others are more active. 

Rebalancing asset-class exposures that vary by a fixed percentage versus a target was a frequently cited approach. Several accumulators said they restore balance with new portfolio additions, while retired investors said they did so by taking withdrawals from areas that had enjoyed sizable appreciation.

To read the complete thread or share your own views, click here.

'No, I Don't Rebalance'
Wenzela tends not to rebalance, instead making changes only when investment fundamentals dictate it. "As a dividend growth investor I buy when a value opportunity occurs, and sell when a position no longers fulfills my personal requirements. Beyond that, no need to rebalance just because the market yo-yos occasionally."

GregLee's post underscores that rebalancing requires an appreciation of strategic allocation, which he doesn't share. "No, I don't rebalance. I don't do the asset-allocation thing, at all, for the reasons: 1) I don't know my risk level, and I have no reason to think it remains constant (which seems to be the asset-allocation theory); 2) I don't want to hold bonds because of the risk that rates will rise."

Even posters who are sold on the merits of rebalancing note that it can be psychologically difficult. BMWLover wrote, "I'm bad about rebalancing our portfolio to our targets, especially recently with the equity markets doing so well. I have an overall target of 70% stocks and 30% fixed income, but with the stocks continuing to grind higher and the potential for interest rates to rise thereby causing bond values to drop, I have not been enthusiastic about reallocating into bonds." 

And unless one has a portfolio of simple index funds, rebalancing can be complicated and trigger a tax bill. Rideon49 wrote, "I have been slowly trying to rebalance for about a year now, no easy task. The problem I have come to is the tax considerations to think about when making a move. Also I am looking for a program to help, sure would make it a lot easier. By the time I'm done I will probably have to go the other way because we will be in a bear market by then."

'That Is How You Buy Low, Sell High!'
Yet most respondents in the thread believe that rebalancing is worth it.

SkylerDexter wrote, "I do like to rebalance because that is how you buy low, sell high!"

Darwinian noted that rebalancing can be particularly effective if one makes intra-asset-class adjustments, rather than simply adjusting exposures to the major asset classes, writing, "Bogle is partially correct in observing that rebalancing is not always successful. During a secular bull market, if an investor holds only a stock index fund and a bond index fund, he may reduce his net gains by selling stock that will continue to rise. However, if an investor holds a diversified set of stock funds, such as large-cap, small-cap, and international, rebalancing among them can enhance returns in any market, as they will outperform at different times."

Ridg0008 believes that because rebalancing necessitates an annual checkup of the portfolio, it's a healthy practice. "When my spouse and I were working, we did an annual review of all our assets. But since most of what we had was in 401(k)s, we reviewed those quarterly. The main benefit of quarterly checkups was almost certainly the fact that it made us look at things regularly and talk about our financial situation even if we didn't make any changes." ​

'I Would Rather Miss Part of the Ride Than Miss All of the Ride Into Retirement'
Posters varied, however, in how they implement rebalancing--specifically, the triggers they use to make changes.

One of the more hands-on rebalancers is trueblue, who wrote, "I go with [Yale University chief investment officer] David Swensen's idea of relatively frequent rebalancing. This ends up meaning rebalancing every two to 10 weeks. I use  Charles Schwab (SCHW) supermarket funds to rebalance, so there are no costs of buying or selling. This relatively frequent rebalancing means that I miss the profits on some longer-term trends but do pick up substantial gains incrementally when the market is jittery."

Yet Yogibearbull warns that investors need to be careful not to churn. "Too frequent rebalancing is not good. A strict rebalancing by time isn't good either. So rebalance when the portfolio moves a certain percent [3%-5%] from the targets."

Also focusing on variations relative to the target allocation is Darwinian, who wrote, "I generally follow the 'Opportunistic Rebalancing' strategy described by Gobind Daryanani in the Journal of Financial Planning, January 2008. His proposal includes a) monitoring a portfolio relatively frequently, once or twice a month, rather than just an annual Couch Potato check; b) rebalancing each asset class individually, as needed, rather than all at once; c) Setting a "guard band," say 20% of an asset's intended target, so an asset with a target of 10% of total portfolio value will not be rebalanced unless it is more than 12% or less than 8%; d) don't automatically rebalance all the way, but only move halfway back to the target, to take advantage of momentum."

Tomas47 has wisely set out portfolio-checkup and rebalancing parameters as part of an investment policy statement. "In my investment policy statement, I require quarterly allocation reviews and rebalance only if out of range. My ranges around classes and sub-classes are 25% of the target, or 5% absolute, whichever is less. I only require re-balancing to range, not necessarily to target. In actual practice, I check the allocation monthly. Also, if I need to withdraw funds, or if I am adding funds, I will go to the class or subclass furthest from target."

Of a similar mind is ColonelDan, but this investor also stays plugged into personal circumstances. "I will only rebalance when my situation changes or my asset allocation strays significantly from the target by a factor of 5% or greater."

Texasboy has also used life stage as a trigger to rebalance: "Up until now my rebalancing has come as a result of changes in my desired asset mix because of aging and from going from working to retired."

Indeed, several posters noted that rebalancing gets more complicated when retirement draws near. Zorkl55 wrote, "[Financial-planning author] William Bernstein has written convincingly that one ought to simply take money off the table at the point of reaching one's target portfolio value. I saw too many colleagues either delay retirement, or forgo it, in 2008. I would rather miss part of the ride up than miss all of the ride into retirement. As a result, I have lowered my percentage of assets allocated to stocks, and will continue to take a little off the table if the market continues to ride up. I am keeping under 30% in stocks, lower than at any point in my life (I'm 65). If the market drops 30%-40% (which it will inevitably do at some point) I will not have to drop at my office desk as a result, because I couldn't retire. If the market keeps soaring, well, so be it. It'll be gravy."

'When Market Valuations Get Lofty, I Get Nervous'
Rebalancing advocates also varied on the logistics of getting their portfolios back into line with their targets. Making changes can trigger tax consequences, so most posters urged rebalancing within tax-sheltered accounts and letting new contributions or required minimum distributions help move the asset-allocation needle.

Valuation considerations are the main impetus for Dragonpat to rebalance; she does so by steering new contributions to the unloved parts of her portfolio. "On the whole, I rebalance by directing my new contributions to areas I feel look underpriced. When market valuations get lofty, I get nervous and have shifted assets around into other sectors when the price to book or price to sales start to look too high for particular kind of funds. In fact I am getting nervous now and have been shifting some assets into international, which looks relatively underpriced now."

NormanR, who aims to be hands-off about rebalancing, also uses new additions to help restore order. "The easiest way I have found to rebalance is to first allocate discretionary purchases to those areas that are lagging. I have an annual list of preferred purchases, and that list is very helpful."

SkylerDexter also fixes imbalances by directing new contributions to areas that look light relative to targets. "The main way I rebalance is when my 401(k) gets my weekly contribution, I look at my portfolio [with Morningstar's X-Ray tools], see which sectors or Morningstar Style Box values need to be increased, and add the new contribution to funds that fix that." 

Only as a last resort does this investor actually sell: "Sometimes, when a fund has really made some gains, I may sell some of it (like  Primecap Odyssey Aggressive Growth (POAGX) which I love but don't want to get too big)."

On the flip side, bill heitbrink notes that decumulators can rebalance by making withdrawals. "I am retired, and I have been taking distributions from appreciated assets. 

Given low bond yields, this investor is also deploying new "fixed income" investments into higher-returning--and guaranteed--mortgage paydowns: "Also, I consider prepaying a small mortgage as an alternative to putting money into fixed income."

BillinGA is wisely knitting his portfolio management together--including rebalancing--with tax and RMD considerations. "Because I'm taking about $20,000 a year out of sheltered accounts as distributions now to avoid large, tax bracket changing required minimums when we turn 70, this builds in a rebalance opportunity as we don't need that money for income at this time."

Jomil is a fan of automating rebalancing to the extent possible, writing, "I follow an automatic rebalancing system by using available brokerage features of directed dividends, direct deposit, and automatic exchanges. Some brokerages will do automatic rebalancing if you request it."

Another easy way to rebalance is to use all-in-one funds. "Balanced funds and static allocation funds take care of the lion's share of maintaining a desired allocation for me." Jomil wrote.

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