Rebalance Your Investment Portfolio [How & When]

By Dr. Jim Dahle, WCI Founder

I thought it might be a good time to revisit and discuss a few things about rebalancing your investment portfolio, including the why, when, and how.

Why Rebalance Investment Accounts?

The whole point of the “know-nothing” fixed asset allocation approach to portfolio management is that you have no idea what is going to happen in the future. It is a very liberating idea because it allows you to quit spending time on activities that do not add value to your portfolio. The idea is that you focus on the things you can control—like asset allocation, costs, tax management, and receiving the “market return”—and forget everything else. Basically, you set up your asset allocation to be something like this (and I’ll use my parents’ portfolio as an example):

• US stocks: 30%
• International stocks: 10%
• Small value stocks: 5%
• REITs: 5%
• TIPS: 20%
• Intermediate bonds: 20%
• Short-term corporate bonds: 5%
• Cash: 5%

Over any given period of time, one of these asset classes will do better than the others, and conversely, one will do more poorly. I have no idea which, except in retrospect. However, as the percentages change, the amount of risk the portfolio is taking on changes. For example, if stocks do great for 10 years and bonds do poorly, it is quite possible that instead of a 50/50 portfolio, this portfolio becomes 75/25. A 75/25 portfolio rises much quicker when the market goes up, but it also crashes harder in a temporary or permanent downturn (the real risk of investing).

More information here:

How to Build an Investment Portfolio for Long-Term Success

The 15 Questions You Need to Answer to Build Your Investment Portfolio

Rebalancing Your Investments Gives the Investor 3 Things

#1 Risk Control

It returns the portfolio to the desired amount of risk.

#2 Rebalancing “Bonus”

It forces you to buy low and sell high, although, in general, this one is a bit of a myth. Since “high-expected return” assets like stocks actually have higher returns most of the time, selling a high-expected return asset class and buying a low-return asset class probably lowers overall returns, despite any “bonus” from buying low. However, the discipline it instills to buy something that hasn’t been doing well does a lot for an investor’s ability to stay the course.

#3 Something to Do

Many investors have a curious need to tinker with their portfolio. I only mess with my parents’ portfolio twice a year. First, to rebalance, and second, to take out a Required Minimum Distribution (RMD). Frankly, you can do both at the same time if you like. Portfolio management can literally be that easy. It is honestly less than an hour a year. It costs them 9 basis points a year for the fund’s Expense Ratios (ERs), and it provided an annualized return from mid-2006 through 2014 (through one big bear and one big bull) of 7.42% per year. My parents feel zero need to tinker, but many investors do. At least rebalancing gives them something to do rather than make a behavioral investing mistake.

When to Rebalance Your Portfolio

There are two schools of thought about rebalancing.

#1 Rebalancing Based on Time

The first is that you should rebalance based on time. Some people do it once a year—on the first of the year or on their birthday, for example—when taking RMDs or when making an annual contribution. The data shows that you probably should not do it any more frequently than once a year and that every 2-3 years is probably fine. That’s not going to do much for the tinkerer, of course.

However, if you’re relatively early in the accumulation stage, rebalancing once a year assumes that you’re making relatively balanced contributions into your accounts. I’m not.

Given my multi-asset class portfolio, it would be way too much of a pain (and a cost) to contribute to every asset class every time I add money to the portfolio. So, I tend to look at what’s done poorly recently and rebalance with new contributions as I go along. As a young accumulating investor, it generally takes massive market movements for you to have a need to actually sell anything anyway.

#2 Event Focused

The second school of thought on rebalancing is that it should be event-focused. These folks tend to use rules like the 5/25 rule. That means if an asset class is “off” its target allocation by more than 5% absolute or 25% relative, you rebalance the entire portfolio immediately. To demonstrate how this works, let’s look at a snapshot of my parents’ portfolio from a decade ago.

Does the portfolio need to be rebalanced? Well, it’s a little low on cash at 4%. But the difference between 5% and 4% is less than 5% absolute and less than 25% relative (meaning 1.25% absolute for a 5% asset class). The US stocks are a little high at 34%, but that’s also both less than 5% absolute and 25% relative (meaning 7.5% for a 30% asset class). However, international stocks are up to 13%. While that is less than 5% absolute, it is MORE than 25% relative (2.5% for a 10% asset class). So, it is time to rebalance the portfolio.

The downsides of an event-based rebalancing plan are 1) you have to look at your portfolio more than once a year and 2) you might be rebalancing more frequently than is good for your portfolio. Sometimes, due to momentum, it actually helps to let the winners run for a little bit, which is why rebalancing no more often than once a year is probably a good idea.

More information here:

The Mechanics of Portfolio Management

How to Rebalance Your Investment Portfolio

You’ve determined that it is time to rebalance. How should you do it? Rebalancing doesn’t make a HUGE difference, so it is very important that if you are going to do it, you minimize the costs of doing so, lest the costs outweigh the benefits. Here are some tips to reduce costs:

#1 Rebalance the Whole Enchilada

It is generally not a good idea to have the exact same asset allocation in all your accounts. Thus, you don’t want to rebalance your accounts individually. Consider it all one big portfolio (at least all accounts aimed at one goal, like retirement), and manage it that way.

#2 Make a Chart

Use a spreadsheet or other chart like the one above. You can even add a column showing the dollar amounts to buy and sell with minimal Excel knowledge. It might look like this:

#3 Tax-Loss Harvest

If you have losses in a taxable account, tax-loss harvest them. Three thousand dollars worth of losses can be taken against your regular income on your taxes each year and carried forward to future years. Plus, losses can be used to offset any gains you may have from rebalancing. In fact, you should be tax-loss harvesting any time you have a significant loss, not just when it’s time to rebalance.

#4 Use New Contributions

There is no cost to rebalancing with new contributions, so use them to rebalance as much as you can. If you are a beginning investor, it might be decades before you have to actually sell something to rebalance.

#5 Dividends/Capital Gains

If you avoid reinvesting your dividends and capital gains in a taxable account, those work just as well as new contributions.

#6 Beware Commissions

Depending on your strategy (mutual funds vs. ETFs), there may be a commission and a spread associated with buying and selling. Try to do your rebalancing in an account with no transaction costs. For example, a Vanguard Roth IRA invested in Vanguard mutual funds has no transaction costs, so it is a great place to rebalance.

#7 Taxes Are the Largest Transaction Costs

As a general rule, your largest transaction costs are taxes, so it is best to do your rebalancing inside 401(k)s, Roth IRAs, or other tax-protected accounts rather than a taxable account, where it may generate capital gains. The goal is to rebalance for free. My portfolio would have to be REALLY out of whack before I actually paid money to rebalance it.

#8 Don’t Pursue Perfection

I’ve become much more laissez-faire about rebalancing in the last few years. It just doesn’t matter that much. Besides, the day after you rebalance, your portfolio will just be “out of whack” again. So, don’t get worked up about it. For example, your portfolio might include 10% investment real estate that is particularly hard to rebalance due to liquidity issues and transaction costs. You just can’t sell 6% of your apartment building. Either deal with it or simply add a similar, but more liquid investment (like a REIT index fund) to that particular asset class. Then, you can do the rebalancing with the REIT fund. Is it perfect? No. Does it need to be? No.

Likewise, some 401(k)s (like the Federal TSP) make things tricky. You can only rebalance the account based on percentages, not dollar amounts. That’s fine if it’s the only investment account you own. But if you’re like me, you have to convert the percentage amounts to dollar amounts before putting in the transaction orders.

Also, keep in mind that buy/sell orders have to go in at different times of the day depending on the account. If you’re using ETFs, they have to occur while the market is open. With the TSP, the deadline is noon ET. With Vanguard, the deadline is 4pm ET (at market close). Although you don’t need perfection, it’s probably best to try to get in all your buy/sell orders on the same day when rebalancing.

#9 Take Advantage of Automation

If you’re lucky enough (or unlucky enough) to only have a single investment account, feel free to use an auto-rebalancing solution such as a Vanguard Target Retirement or Life Strategy fund. This works with multiple accounts also, as long as they all have that particular investment available. Just be aware that if one of those accounts is taxable, you may be giving up a little on the tax side to improve simplicity.

Still seem too complicated? Then, hire an advisor. I list many low-cost ones here, even if the lowest-cost one can be found in your mirror each morning. If rebalancing seems too tough, actually putting the portfolio together in the first place will probably be overwhelming. The fewer the asset classes and the fewer the accounts, the easier portfolio management will be. You simply have to balance that ease of management against the possibly higher returns (and the fun you’ll get tinkering) from making things more complicated.

Though my rebalancing these days is ridiculously complicated, it wasn’t particularly complicated in the beginning. Just like learning to do your own taxes in residency only requires you to learn one or two new things every year, adding another asset class or account every now and then isn’t that big a deal. Excel is your friend.

What do you think? Why do you rebalance your portfolio? When do you do it? How do you do it?

[This updated post was originally published in 2015.]