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Cut the Cost of Rebalancing

If investors wait to rebalance until their targets are off by 5% or more, it would help them maintain their risk-return profile, and also minimize the cost of rebalancing, says Colleen Jaconetti of Vanguard Investment Strategy Group.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com.

I recently interviewed Colleen Jaconetti. She is part of Vanguard's Investment Strategy Group. We discussed why you should rebalance and also how often you should do it.

Colleen, thank you so much for being here.

Colleen Jaconetti: Thank you for having me.

Benz: So, Colleen, it seems that most people in the investment community agree that rebalancing makes sense in terms of reducing investors' risk level in their portfolios, but I know from practical experience, investors often wrestle with how often to rebalance, should they do it at the end of each year or should they do it when they see big divergences versus their target asset allocation? You all have done some great research on this topic. What did you do and what did you come up with in terms of optimal rebalancing rates?

Jaconetti: Yes, while our research really looked at rebalancing annually, semiannually, quarterly or monthly. And we really were trying to see whether if you rebalance more frequently, if you actually tracked your asset allocation more closely, which you did, but there's also a cost to rebalancing.

Benz: So, tax costs, transaction costs, potentially?

Jaconetti: Exactly. So what we found was, if people would monitor their portfolio either semiannually or annually, and then rebalance when the portfolio actually is out of target by 5% or more, it would help them to not only keep the risk and return of the portfolio, but also minimize the cost of rebalancing.

Benz: So, I often talk to people who want to keep very tight control on their asset allocation, and so if they see that equity percentage scoot maybe a percentage point or two higher than their targets, they want to scale back. You think that's too frequent?

Jaconetti: That might be too frequent. It really all depends on what the investor is comfortable with. So, it can cost money to rebalance. So, if 1% out of whack causes them to lose sleep at night then they might want to rebalance, but they have to realize that the cost of rebalancing might actually cause them to have a lower return than a target asset allocation. So it's kind of balancing the risk that they are willing to take versus the cost that they are willing to incur to make sure their asset allocation tracks closely.

Benz: Okay. So, when you are talking about a five percentage point divergence, you are looking at the major asset classes right? You are not looking at sub-asset classes?

Jaconetti: Exactly. So, we would say the stock-bond balance is out by more than 5%. So if someone has a 50% stock, 50% bond portfolio, if it's more than 55% in stocks they would want to rebalance the portfolio.

Benz: Okay. How about for more hands-off investors if they feel comfortable letting things ride or don't want to be in charge of such day-to-day oversight or year-to-year oversight, and maybe would be willing to let their percentage-point divergences run up to 10 percentage points--is that too much? Do they introduce extra volatility in the portfolio?

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Jaconetti: There could be extra volatility, so depending on what's going on in the markets, how far out of balance they get, and then if there was, say, a correction, so if their portfolio went from 50% stocks, 50% bonds to 60% stocks, 40% bonds, and the market dropped by 40%, they would just need to be comfortable that they actually had more exposure to stocks during a period when the market went down.

Benz: Okay. And how did you study this issue? Did you model different portfolio scenarios?

Jaconetti: We did. We modeled portfolios, basically taking a 60/40 [allocation] and we compared that to monthly rebalancing no matter what, and then we rebalanced at 1%, 5% and 10% increments, monthly, quarterly, semiannually and annually. So we really saw that the differences were not meaningful except for a portfolio that was never rebalanced. So it wasn't significantly different if you rebalanced at 1% versus 10% other than the cost of rebalancing, and whether you looked at it quarterly versus annually other than the cost. So your asset allocation risk and return didn't get that far out of whack. So, the important thing is to rebalance and pick a frequency that you are comfortable with because the biggest difference is versus a non-rebalanced portfolio.

Benz: Right, Right. Well Colleen, thanks so much for sharing that research. I know that people are often looking for some practical guidelines on this, so it's very helpful.

Jaconetti: Great, thank you.