Portfolio rebalancing: Why, when and how much

Have you ever made the mistake of driving on the highway without clearing the snow caked into your car’s wheels? As you get up to speed, a vibration builds through the steering wheel. If there’s a lot of snow, it can be so violent you’ll think your fillings are about to fall out and the car is ready to shake apart. The fix is simple: find a safe opportunity to pull off the road, clear the snow from your wheels with your snow brush, and the vibration goes away. Balance has been restored.

Disciplined investors strive for balance in their portfolios as well. Your asset allocation—the mix of volatile stocks and more stable bonds—largely dictates how bumpy your ride will be. A portfolio with 90% exposure to equities is going to feel like being in a Formula 1 race car, while a portfolio of 90% high-quality fixed income might feel more like riding in a horse-drawn carriage. Either of those is fine, as long as it’s matched to your expectations and requirements.

Choosing the right asset allocation is likely the most important investment decision you’ll make, so it’s crucial to get it right. Your target mix of stocks and bonds should be based on your time horizon, the rate of return you need to meet your goals, and your own comfort level with the ups and downs of the markets. There’s just one problem: starting from day one, your actual asset allocation will change as markets move.

Say you have a portfolio with a target mix of 50% stocks and 50% bonds. If stocks soar and bonds plummet, or vice versa, your equity allocation could become 60% or 40% bonds. Then your carefully designed portfolio would have fundamentally different risk and return characteristics—your horse-drawn carriage can suddenly find itself on a race track. This is why we occasionally need to pull off the road and rebalance by adding money to the asset classes that are below their targets and trimming back those above them. That restores your portfolio to its original asset mix and keeps your risk under control.

Does it boost returns?

There is a misconception that rebalancing boosts the returns in a portfolio because it’s a way of always “selling high and buying low.” Consider our portfolio of 50% equities and 50% fixed income. If stocks have a poor year and lose 12% while bonds are up 3%, your new asset allocation would be roughly 46% stocks and 54% bonds. Rebalancing would entail selling some of your bonds to buy more stocks to bring your allocation back to 50/50. If stocks rebound the following year, you’ll feel pretty good. And if your allocation to stocks moves above its target, rebalancing back to 50/50 will cement some of your gains. This sounds like an appealing way to get better portfolio performance.

Unfortunately, it’s not that simple. To understand why rebalancing is not always a return booster, take a step back and remember that over the very long term stocks are expected to outperform bonds. Let’s assume a portfolio of 100% stocks will return 6%, and a portfolio of 100% bonds will return 3% on an annualized basis. If each asset class had a straight line of performance—that is, if stocks returned 6% and bonds returned 3% each and every year—rebalancing would mean always selling off your long-term winner to buy your long-term loser.

Of course, we know markets don’t move in straight lines, but they do see long trends. When you have asset classes that have very different risk and return characteristics—like stocks and bonds—rebalancing can either boost or reduce returns depending on how the markets behave. Rebalancing after the financial crisis of 2008-09 would have been a huge benefit as stocks recovered rapidly over the next several years. But if you bought more stocks after the dot-com bubble burst in early 2000 you may have seen them fall again in 2001, and even further in 2002. “Buying low” doesn’t mean prices can’t fall even lower.

Tom Bradley, the founder of Steadyhand Funds, says some studies demonstrate you can get a boost in returns from rebalancing, while others show the opposite. It’s all about the specific time frame. “Rebalancing can add returns in choppy markets but reduce them in trending markets,” he says. “The value of rebalancing has more to do with risk control and managing investor behaviour than boosting returns.”

You’re more likely to see rebalancing increase returns with asset classes that don’t move in lockstep but have similar risk and return characteristics. For example, Canadian and U.S. stocks are unlikely to have the exact same long-term rate of return, but over the last four decades they were pretty close, so rebalancing between these two asset classes should not cause a significant drag over time. And since we know one country will outperform the other over shorter periods, regularly adding to the one that has lagged (and is therefore “cheaper”) could give a modest boost to your long-term performance.

It works on two levels

If you’ve read about rebalancing in the pages of MoneySense, it was likely to be part of a discussion about Couch Potato investing, since sticking to a long-term asset allocation is a pillar of that strategy. But rebalancing is crucial whether you’re using index ETFs, actively managed funds or individual stocks. It’s always important to consider how all the parts of your portfolio work together.

In practical terms, rebalancing is a little harder if you buy individual stocks rather than a single fund for each asset class. Stock pickers should consider rebalancing on two levels. Not only do they need to consider their overall mix of equities and fixed income, but also any imbalances among their individual holdings. Mark Seed, author of the popular blog MyOwnAdvisor.ca, prefers dividend investing over indexing for his personal portfolio, and he acknowledges this challenge. “When asset allocations fall out of range, I think it’s much easier for an indexer to recognize that,” he says. “Most indexed portfolios can be built with just four or five funds. Dividend portfolios—at least diversified ones—are constructed with 10, 15, 20 or more stocks. That’s a lot of companies to manage and it can complicate the rebalancing process.”

These investors can potentially boost their returns by rebalancing, since the stocks should have similar return expectations. The problem is the number of transactions required: more trading means higher costs from commissions, bid-ask spreads and taxes. There are a couple of possible solutions. If you’re regularly adding to the portfolio it may make sense to rebalance by simply using new cash to prop up any holdings. (This is especially useful in non-registered accounts, where selling stocks can generate taxable capital gains.) It can also be a good idea to take dividends in cash rather than reinvesting them, and then using that money to make a single purchase once per quarter, say, to bring the portfolio as close to the target asset allocation as possible.

How often is enough?

If the goal of rebalancing is primarily to maintain a target asset allocation and manage risk, then everyone should be doing it. The question is, how often?

Before we can tackle that question, we need to explain the two main criteria for triggering a rebalance. The first is time: for example, you might schedule a rebalance once or twice a year on predetermined dates. A second approach is to rebalance only when an asset class drifts away from its target by a specific amount—say, five percentage points.

Let’s start with rebalancing purely based on the calendar. What is the optimal amount of time between rebalancings? The answer again depends on the data you look at. There are studies that suggest once every two years is best because it lets you take advantage of momentum. That makes sense intuitively, since bull runs tend to last a few years. Why reduce exposure to the asset class that’s on a multi-year hot streak when we know that rebalancing can lower returns in trending markets.

Other studies have shown quarterly rebalancing beats annual rebalancing. One looked at U.S. market data from 1968 to 1991 and concluded monthly rebalancing beat them both. The fact is, research has found no clear winner when it comes to an optimal rebalancing interval. It depends on the time period you consider, which isn’t any help when we’re looking forward into a future where we don’t know what kind of markets we are going to get. If you’re looking for a simple solution, you may simply make a habit of rebalancing once a year, perhaps when you make your annual RRSP or TFSA contribution.

Rebalancing based on thresholds requires you to keep a closer eye on your portfolio. With a simple 50/50 target, an investor might decide to rebalance any time stocks or bonds drop below 45% or rise above 55%, and the volatility of the markets will dictate how often this happens. It might take a couple of years or longer, but during an event like the financial crisis of 2008 it might happen in a week. If rebalancing is shown to produce a bump in returns in volatile markets, then this might be worth the hassle.

Rebalancing based on thresholds is easy when your portfolio has just a couple of asset classes. But it’s trickier when you add more asset classes and smaller allocations. Your equity target might include a 10% weighting to emerging markets, for example. How do you establish your thresholds for rebalancing now? A move of five percentage points would now require a 50% return or a 50% loss, both of which aren’t likely to happen very often.

With multiple asset classes, you should first consider the overall ratio of equities to fixed income. You can also set individual thresholds for each asset class in your portfolio. If you have a target of 50% for bonds you might let that drift to between 45% and 55% before triggering a rebalance, but with emerging markets you might set a narrower range of 8% to 12%.

If you’re regularly adding or withdrawing from your portfolio, that’s an opportunity to keep your asset allocation on target over time. You can simply direct your contributions to the assets below target and take withdrawals from those that are overweight. If the portfolio is small relative to these contributions or withdrawals, the cash flows alone could keep you on target, though with larger portfolios they may not move the allocations enough.

Always count the cost

Any time you rebalance, you need to factor in transaction costs and taxes. If you are buying and selling stocks, ETFs or individual bonds, there will always be transaction costs, including trading commissions and bid-ask spreads. It might not be worth the costs if your portfolio is small and you need to make multiple trades to rebalance. If your discount brokerage charges $10 per trade, for example, every $500 transaction would cost you 2%, which will take a bite of your returns over time.

Mutual fund investors may not have to pay commissions to buy or sell, but short- term trading fees—typically 2%— can apply if you make excessive trades within a 90-day period. Find out the details if you plan to rebalance your mutual funds more than once or twice a year, or shortly after making an initial purchase: these fees may be waived if you, or your adviser, call up your fund company and give them a heads up.

In tax-sheltered accounts like RRSPs and TFSAs you don’t have to worry about taxes, but in non-registered accounts rebalancing has another potential cost. Selling assets that have gone up in value can crystallize capital gains, which are then taxable at half your marginal rate. This also creates a little more paperwork: you’ll need to keep accurate records of the transactions so you can adjust your cost base.

You should also be careful to carry forward any losses and use them to offset your gains. There is some merit to dovetailing your rebalancing schedule with any tax-loss selling you might be doing in your non-registered accounts.

Pulling the trigger

On the surface, rebalancing seems like an almost trivial concept. What’s so hard about keeping your portfolio’s risk in line with your long-term target? Don’t you just make a couple of trades once or twice a year and get on with your life? You might think so. But that ignores how emotionally difficult it can be to execute a simple rebalancing plan.

• For information on how to exactly rebalance read, “Getting back to balanced.”

Threshold rebalancing can be especially difficult. With time-based rebalancing, your scheduled date will often come after a period when stocks and bonds have both gone up, but at different rates. That’s an easier situation to deal with emotionally. But when you’re rebalancing with thresholds, you’ll only make trades after one asset class tanks hard—and you’ll be buying that beat-up asset. For example, if you have a global portfolio and rebalance at the end of every year, then in 2013 you would have been selling U.S. and international stocks (which enjoyed lofty returns of 30% to 40%) and buying bonds, which had their worst year since 1999. How many people actually did that?

Steadyhand’s Tom Bradley says volatile markets offer the best opportunity to boost returns by rebalancing, “but that’s also the time when investors are less likely to stick to their plan.” Don’t underestimate how hard it is to pull the trigger and buy the asset class no one else wants. One way a good adviser can add value is by helping you stay on course and execute your plan. If you use a financial adviser, your rebalancing strategy should be included in your Investment Policy Statement (IPS).

While it can be tempting to look for the “optimal” rebalancing strategy, the experts suggest not getting bogged down in the details. When you are still building your savings, rebalancing with new cash flows will probably be all you need to do for a few years. Once your portfolio starts getting bigger you’ll have to decide whether to rebalance based on time, thresholds, or a combination of both. Bradley says a simple annual rebalance is fine for most people: that’s usually enough to keep your risk level consistent. “The more automatic you can make it, the more you’ll take emotion out of the equation,” he says. “The less you invest with emotion, the better off you’re going to be.”

Sounds like a recipe for balance in life as well as in your portfolio.