Bob French, CFA

Rebalancing Frequency

Almost everyone agrees that rebalancing your portfolio is one of the keys to having a successful investment outcome. We know that your asset allocation determines how your portfolio will perform. Successful investors spend a lot of time determining what they want to include in their portfolios, and how they want to spread out their assets. Once you put your portfolio into practice, the markets have ideas of their own. The market is going to drag your beautifully designed portfolio through every mud puddle it can possibly find. It’s your job to pick your portfolio up, dust it off, and point it back in the right direction.

This is where rebalancing comes into play. Rebalancing brings your portfolio back into line, and ensures that you are (roughly) taking the right amount of risk through time. There are other benefits to rebalancing that people talk about – most notably that it systematically forces you to buy low and sell high – but keeping your portfolio dialed in on your appropriate level of risk is the big one. If you don’t periodically bring your portfolio back into alignment, then all the time you spent lovingly crafting your asset allocation will be wasted. Pretty quickly, the market will make sure that your portfolio doesn’t have all that much relation to the one that you designed for yourself.

So, now that we know why we want to rebalance, how do we actually go about doing it?

Well, the basic idea is to sell the things that are overweighted in your portfolio relative to your asset allocation, and buy the things that are underweighted in your portfolio relative to your asset allocation. But this just raises the question of when to rebalance your portfolio. Your portfolio is constantly on the move, so you could theoretically rebalance your portfolio every day if you really wanted to. This would ensure that your portfolio is as close to your intended portfolio as possible, but you would incur all sorts of costs – taxes, potential transaction costs, and also, the cost of your time (which most people ignore completely). What we want to do is figure out how to maximize the results while minimizing the costs that you incur while doing so.

There are two main approaches to this task. The first approach, and the one that we’ll focus on here, is the time-based approach, where you rebalance on a set schedule. The other approach is called the rebalancing band approach, which doesn’t rebalance until an asset class moves outside of prespecified bands. In other words, it lets the portfolio run until it drifts too far out of line, and then it brings that portion of the portfolio back into line.

Rebalancing bands are used by a lot of financial advisors (including McLean Asset Management), and there’s evidence to believe that they produce better results than time-based rebalancing. The downside to this approach is that it requires you to keep a very close eye on your portfolio to see when things are drifting out of balance. This is fine for financial advisors (it’s one of the things that we’re paid to do), but the marginal benefit for individual investors is awfully small relative to the extra attention required, which is why most individual investors (assuming they rebalance at all) use time-based rebalancing.

With that in mind, let’s look at how often you should rebalance if you use time-based rebalancing.

The most common time frame that people use is annual rebalancing. They go in once a year to clean up their portfolio. But, I want to look at whether this is the optimal frequency or not – or if there is even such a thing as the “optimal” frequency.

To answer this, I created a reasonably simple 60/40 index portfolio:

 

S& 500 Index 30%
Russell 2000 Value Index 5%
MSCI EAFE Index 20%
Dow Jones US Select REIT Index 5%
Bank of America Merrill Lynch1-3 Yr US Treasury Index 40%

 

Now, normally, I would just have a simple stock and bond portfolio, but I want to give the rebalancing some space to do its work. The more asset classes you use, the more degrees of freedom has to work with, and the larger the effect will be (this isn’t a reason to put everything under the sun in your portfolio though).

I’ll use annual rebalancing as our base case, but I also want to consider differing rebalancing lengths.

But before we look at the numbers, what do we expect to happen here? Well, we know that stocks and bonds have different expected returns, so the longer that we let a portfolio run without rebalancing, the further the portfolio will be out of balance. Since stocks have higher average returns than bonds, we should also expect that the longer a portfolio goes without rebalancing, the more tilted towards stocks it will be. Given this increase in stocks, we should expect portfolios with more infrequent rebalances to have higher levels of risk (and the commensurate returns) than portfolios that are rebalanced more frequently.

The data reflects this.

Let’s start with the raw return numbers.

 

Rebalancing Frequency Annualized Return Standard Deviation Growth of $1
Quarterly 9.41% 8.51% $34.63
Annual 9.50% 8.49% $35.77
2 Years 9.71% 8.60% $38.53
5 Years 9.76% 8.97% $39.30
Never 10.15% 11.08% $45.13

For illustration purposes only. Data from 1/79 – 5/18. Portfolio allocation provided above. Indexes are not available for direct investment. Past performance is not indicative of future performance. Data courtesy of Morningstar.

 

This lines up with our expectations; the more leash you give the portfolio, the further it will run. The portfolios that were rebalanced less had higher returns, as well as higher standard deviations.

At this point, it’s worth pointing out that these results will (to some extent) depend on exactly when each of these portfolios is rebalanced – especially with the less frequently rebalanced portfolios, as that will determine what these portfolios look like when big market movements hit. For instance, if the portfolio that is rebalanced every five years happened to have been rebalanced right before the markets came tumbling down in 2008, it wouldn’t have been hit nearly as hard as one that had been rebalanced back in 2004. The portfolio that hadn’t been rebalanced in a while likely would have had a higher level of equities, and would have taken it on the chin when the bottom fell out of the market.

But that is exactly the point here.

We rebalance to minimize the risk of something like that happening. Otherwise, we might as well put it all in stocks and be done with it. Let’s dig into this point. How does rebalancing frequency actually affect the level of stocks and bonds in the portfolio?

A good way to see this is to look at the average level of bonds in each of these portfolios (other than the never rebalance portfolio.) Just like with the returns, the results are pretty much what we would expect to see.

 

Rebalancing Frequency Average Weight of Bonds in Portfolio Standard Deviation of Weight of Bonds
Quarterly 39.81% 1.58%
Annual 39.40% 2.58%
2 Years 38.40% 3.58%
5 Years 36.72% 4.91%

For illustration purposes only. Data from 1/79 – 5/18. Portfolio allocation provided above. Indexes are not available for direct investment. Past performance is not indicative of future performance. Data courtesy of Morningstar.

 

The more often you rebalance your portfolio, the tighter you stay to the 40% bonds that your asset allocation calls for. And more than that, the less you rebalance, the more stocks you have in your portfolio on average. The less you rebalance your portfolio, the more risk you bring into your portfolio – with everything that comes with that.

This is the key point. There’s nothing inherently wrong with letting your portfolio run, or better about keeping a tight rein on your portfolio – as long as you understand the decision that you are making. Just like everything else in your portfolio it comes down to your personal preferences. If you can’t stand the idea that your portfolio could significantly differ from what you designed, you need to rebalance more frequently. If you’re comfortable giving your portfolio more room, then it’s not as critical that you rebalance as frequently, but you need to be aware of the real possibility that the market might decide to “stumble” right before you get around to rebalancing – when your portfolio is significantly overweighted to stocks (Murphy says hello).

You need to manage your portfolio to help you stay disciplined for the long term. For most people, that means keeping a reasonably tight leash on their portfolio, and rebalancing reasonably frequently, but it is really up to you. Just keep in mind that what you have in your portfolio, not what you have in your asset allocation spreadsheet, will determine your portfolio’s actual returns.
To learn more about how to take care of your portfolio, read our ebook 12 Principles of Intelligent Investors.

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