Portfolio

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It’s that time of year again. Time to look at your portfolio and decide on your rebalancing strategy. Most investors know they should rebalance but many don’t do it or they get hung up on the detailed mechanics of rebalancing. In this post I’ll present a quick summary of rebalancing approaches and share my approach as well.

We rebalance portfolios to improve risk adjusted returns over the long haul. In general, if portfolios are not rebalanced then the equity portion of the portfolio grows to dominate the overall portfolio and it’s risk. This is usually not something investors want especially as they age. After the decision to rebalance, the next question is how often. The frequency of rebalancing has to be traded off with the costs of rebalancing, transaction fees, commissions, etc… We also need to consider if we should rebalance if there is any difference at all in our target percentage allocations or wait until there is a significant enough difference to trigger an allocation decision. Say your target is 60% stocks and at the end the year you end up at 61% stocks. Does the benefit of rebalancing outweigh the costs? Probably not in this case. So, how does an investor choose the best approach?

Fortunately, the great folks at Vanguard have done all the heavy lifting for us in this paper. Here is the summary table.

Vanguard IMpact of Rebalancing Main Dec 2014

As the above table shows basically there is not a big difference in rebalancing approaches, outside of never rebalancing. Even a monthly rebalance with a 0% threshold does not increase portfolio turnover and costs as much as you would expect. The last column also shows the results of never rebalancing – higher returns but with significantly higher volatility which leads to portfolio outcomes that most investors cannot stick with over time.

These results also hold for quant portfolios. Whether implementing the IVY portfolios, the Permanent portfolios, Quant portfolios, the timing and threshold of the rebalance does not make a significant difference to long term portfolio returns, e.g. see the IVY portfolio FAQ question #4.

However, it is important to point out that there are periods where rebalancing does not work. Let me give you an example. The table below compares the returns of 60/40 stock bond and 70/30 stock bond portfolios with yearly rebalancing and no rebalancing over the last 5 years (2009 to 2013).

Rebal vs no rebal dec 2014

As the table shows, yearly rebalancing increased returns for the 60/40 portfolio but yearly rebalancing actually decreased returns for the more aggressive 70/30 portfolio. This is typical in strong bull markets when stocks consistently outperform. This is maybe one of the reasons investors abandon rebalancing. But it is important to focus on the long term and more importantly on risk adjusted returns and stick to a rebalancing strategy.

Personally, I rebalance once a year with a 1% threshold across all my portfolios regardless of strategy. But that is what I have found works for me. The best advice I can give anyone is to paraphrase the Vanguard advice – choose a regular periodic rebalancing approach that fits your investment style and that you can stick with over the long haul.

This is most likely my last post for this year. Hope everyone has a Happy New Year! Here is to a great and prosperous 2015. At the beginning of the year I’ll be focusing on updating all the yearly returns for all the portfolios and strategies I track. I’m looking forward to sharing the results with everyone.

 

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12 thoughts on “ When to rebalance your portfolio

  1. I’m one of those people that struggles with re-balancing in December-January. With the fund managers all making markets always a little flaky at the end of every year, I normally don’t feel comfortable balancing until February or March once I see where things are going each year. I did jump into some energy funds this month on the assumption that sector is about bottomed out. I’m looking for signs of the bottom for the global/emerging markets, any thoughts there? Thanks!

    1. As long as you rebalance, doesn’t matter when you do it.

      No thoughts on global/emerging markets. I do what my quant systems tell me to do. I’ll be in them when they start going up.

      Paul

      1. Actually, it might matter when you rebalance. If you are rebalancing annually, doing so during dog days of summer might add a little extra value to your portfolio. Please see attached my article from 18 years ago.

        http://www.retirementoptimizer.com/articles/seasonality%20and%20rebalancing.pdf

        However, if you are rebalancing in harmony with the Presidential cycle, then rebalancing in December seems more advantageous.

        The US version of the article (cited by Paul) about “Sustainable….” is also available (using the US indices) at horsesmouth.com (search for author: Otar)

        Keep up the good work.

        1. Thanks Jim. I was referring to the behavioral issue many investors face when confronted with rebalancing. Any type of rebalancing is better than none at all. Many can’t even get past that.

          Paul

  2. Jim Otar’s research analyzing market data compiled from 1900 – 2010 (and summarized here Sustainable Withdrawal Rates of Common Drawdown Strategies ) suggests that rebalancing every 4 years (specifically at the end of the Presidential election cycle) can increase portfolio life and the SWR. This occurs because it reduces the effect of the adverse sequence of returns in distribution portfolios while reducing permanent losses compounded by rebalancing too frequently in multi-year down markets (thus preserving capital) and allowing gains to compound further during secular bull market runs. Thanks for your great contributions!

    1. Bruce, you are doing nothing wrong. Google Sheets is having issues. Other bloggers have are having the same problem. Scott, over at Scott’s investments, did a brief post on it. I have been been able to manually go in and edit any field in the query and change a parameter, and that causes the query to work. Problem is it only works that one time. Hopefully this gets fixed soon.

      Paul

  3. Hi Paul,

    I stumbled across your website by accident and I really like the basic IVY plan–it’s so simple even I can understand it.

    I am not a sophisticated investor by any means; many of the terms and concepts you are so comfortable with are alien to me. I have several diversified mutual funds which have done pretty well in aggregate, but the IVY model really appeals.

    I have some industry-specific funds, some index funds, and some mid and large cap funds. Probably too many, I know, but I’m trying to stay diversified. I tend to be pretty aggressive so ironing out the volatility using the IVY model speaks to me.

    However, I have some very basic–as in, “there are no stupid questions, class” basic–questions. This seems like as good a place to ask the questions as any.

    1. When the model suggests going to “cash” when it drops below the 200-day moving average at the end of the month, what does “cash” mean? I assume we don’t get a bunch of greenbacks to level out the bumps in the mattress. Where do you actually put that money?

    2. Does this work with mutual funds as well as ETFs?

    Thank you, Paul for all the extremely helpful information. Not only are you living the dream, you are helping countless others live theirs.

    1. Andy,

      Thanks for the kind words. Here are the answers to your questions.

      1. The model use the SHY ETF as a cash proxy.
      2. Yes, it would work for mutual funds as well, as long as the mutual funds represent the actual indexes in the model.

      Paul

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