The fine art of rebalancing your portfolio

Q. I started investing with the Couch Potato strategy two years ago. My question involves rebalancing. Would it be better or worse for returns to rebalance every month instead of once a year? I like being a hands-on investor and would not mind the extra time this would require, as long as there was the chance for a small increase in returns over 10 years or more. – Nicholas

A. Even the Couch Potato strategy requires a little maintenance. Your asset allocation—that is, the targets you set for the percentage of stocks and bonds in your portfolio—will drift as markets move. So, from time to time, you may need to sell some of the assets that have gone up in value and use the proceeds to prop up whatever has lagged. For example, after a sharp downturn in the equity markets, you can sell some bonds and use the cash to buy more stocks. This is called rebalancing, and it’s an important part of any disciplined investment process.

That said, rebalancing is often misunderstood. Its goal is not to boost returns; rather, it is primarily a risk management tool. Moreover, there is always a trade-off when rebalancing: It often incurs transaction costs and taxes, so rebalancing too frequently can be counterproductive.

Let’s unpack these ideas a little. Remember that over the long term, stocks have a significantly higher expected return than bonds. So during most periods, rebalancing will involve selling stocks and buying bonds, not the other way around. For this reason, rebalancing a portfolio of stocks and bonds is therefore likely to lower your returns, not increase them.

That said, you might expect a modest increase in returns when rebalancing asset classes that have a similar expected return, such as stocks from different countries. By occasionally selling high and buying low, there is a potential “rebalancing bonus.” But even this is likely to be modest.

To test this, I ran the data for a portfolio with equal amounts of Canadian, U.S. and international stocks (all in Canadian dollars) from 1980 until the end of April 2019. It turns out that if you rebalanced this portfolio once a year, its annualized return over the entire period was 10.4%. And if you never rebalanced it at all? Exactly the same. (This shocked me, too.)

If we look at only the last 10 years (ending April 2019), annually rebalancing an all-equity portfolio actually lowered performance, because U.S. stocks consistently outperformed Canadian and international, so you would have enjoyed higher returns had you just let them run.

So if rebalancing should not be expected to boost returns—and if it occasionally lowers them—why do it at all? The answer is that rebalancing a portfolio is primarily designed to control risk. If you have a carefully designed plan that calls for a portfolio of, say, 60% stocks and 40% bonds, then you shouldn’t stray too far from those targets. If your portfolio drifts to 70% or 75% stocks, it would be meaningfully riskier than it was before, so the prudent thing to do is sell some stocks and buy some bonds to reduce that risk.

So, I hope it’s clear why monthly rebalancing is much too frequent. Once a year is plenty in most cases. Even then, it’s not necessary to rebalance if your portfolio is only slightly askew. As a rule of thumb, consider rebalancing only when any asset class is more than five percentage points off its target. So if you are aiming for 40% bonds, you’re probably fine as long as you are within 35% to 45%. This is especially true if your portfolio is relatively small: for example, if you have $50,000 invested, each percentage point is just $500, which isn’t going to make a meaningful difference in terms of risk or potential return. Once your portfolio is very large, you can make an argument for rebalancing more frequently.

If you are contributing to your portfolio regularly, you can use those cash flows to keep your portfolio balanced. Whenever you add new money, simply buy whichever asset is furthest below its target. During a year when U.S. equities have risen significantly and bonds have declined, for example, just direct your new contributions to the bonds. During a bear market, when stocks will likely fall below your target, use that new money to buy more equities. You will never keep your portfolio in perfect balance this way, but that’s not necessary. Rebalancing is like playing horseshoes: close is good enough.

Dan Bortolotti, CFP, CIM, is an associate portfolio manager and financial planner with PWL Capital in Toronto.

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