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Portfolio Rebalancing Strategies

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Defining a target asset allocation is critical to investment success.

Equally important is ongoing portfolio monitoring and periodically rebalancing the actual asset allocation back to your target allocation.

The Wall Street Journal has a good article on strategies for rebalancing investment portfolios [4].

Worth reading in its entirety, buy I want to highlight a few points. 

Investors Are Poor Rebalancers

Periodic portfolio reviews and rebalancing (as required) are very important to the investment process. Yet many individuals ignore this crucial area.

In a Charles Schwab Corp. survey of American investors approaching retirement, published in November, 20% of respondents said they hadn’t rebalanced their portfolio in the past five years or didn’t know when they had last rebalanced; an additional 9% had never rebalanced.

The probability of long term successful wealth management is very low if you do not rebalance. You need to periodically ensure that your actual asset allocation [5] accurately reflects your target allocation [6].

Be sure to include the mechanics as to how you review your portfolio and the remedial measures you will take when creating your Investment Policy Statement [7].

WSJ Rebalancing Strategies

The Wall Street Journal article looks at portfolio rebalancing on both a calendar and threshold basis.

With the calendar approach, an investor rebalances according to a set schedule (usually monthly, quarterly or annually), regardless of how much—or how little—a portfolio has drifted from its target allocations.

threshold rebalancing is triggered only when a portfolio’s asset allocations change by a set degree. The common rule of thumb is a change of five percentage points in the weightings for the major asset classes in your portfolio.

Some advisers combine time and threshold strategies. For instance, you might review your portfolio every quarter but make changes only if an allocation is out of whack by a set degree.

My Rebalancing Approach

The article is generally in line with my philosophy for portfolio reviews [8] and rebalancing [9].

I like to combine both time and deviations in actual from target asset allocation.

Portfolio Volatility

But I also factor in portfolio volatility.

If you own only low risk assets, your portfolio will not be very volatile. Remember, higher risk equals higher standard deviations equals higher volatility [10]. With less volatile portfolios you should have less fluctuations. So you can increase the time between reviews and reduce the variance from your target benchmark when determining rebalancing thresholds.

If you own nothing but stock options, your portfolio should be highly volatile. In this case, you may want to review weekly (daily?). On the other hand, there may be some extreme short term swings in asset valuation. So a 5% threshold variance may mean that you are constantly buying and selling to return to your target allocation. You will want to increase the thresholds to reflect the higher portfolio risk. Otherwise your transaction costs will skyrocket.

Material Events

Individual and market circumstances may also dictate review and rebalancing.

A material event is something that impacts your decision making. Gas prices at the pump rising 5% may not reduce the amount you drive your car. Gas prices rising 105% may impact your driving plans. Being single lets you lead a certain lifestyle. Suddenly having a baby forces changes on you. The Securities Exchange Commission (SEC) reviewing a company you own shares in may put you on alert. The SEC charging the company with illegal activity may be the material event that causes you to actually sell.

Material events differ between individuals. Obviously, personal circumstances impact people at different stages in life. Not everyone has a baby, loses a job, gets hit by a bus, etc., at the same time.

And an individual’s risk tolerance [11] affects what he or she considers a material event. For those with little risk tolerance news of a potential SEC investigation may be enough to dispose of the company’s shares. Investors with moderate risk tolerance may decide to wait until the result of the investigation before making any decisions. And a very aggressive investor may view an investigation as a buying opportunity.

Regardless of how you view material events, they should factor in to your review and rebalancing.

For example, your policy is to review your portfolio every June 30th and to rebalance when your asset classes deviate 15% from targets. A reasonable combination of the calendar and threshold.

But on March 1st, the government announces new regulations that will negatively impact one of the companies in which you own shares. Should you wait until June 30th or the share price falls more than 15% before assessing and perhaps selling?

Or maybe you get laid off on September 1st and cannot find a new job. Should you wait until June 30th to assess your portfolio? No. In this case, you probably will want to modify your asset allocation. Move into a lower risk portfolio to safeguard exiting capital and generate cash flow to help offset the loss of employment income.

Always Consider Costs

As the article states, watch your costs on rebalancing. They need to be factored into your review and rebalance equation.

And never forget that taxes are a huge cost to investors. So watch when triggering taxable capital gains in dispositions when rebalancing.

I consider the cost issue in my post, How to Rebalance an Investment Portfolio [12].

Summary

Portfolio reviews and periodic rebalancing back to your target asset allocation are crucial for successful wealth accumulation.

Define the process for reviewing and rebalancing your investment portfolio before starting to invest. Use a written Investment Policy Statement [13] as a formal framework to guide your investing program.

Base your rebalancing strategy on a calendar, threshold, or (preferably) combination basis.

When determining your strategy, consider other aspects as well. Factor in portfolio volatility, how material events affect your holdings, your personal risk tolerance, and the impact of costs and taxes when rebalancing.

If you follow these tips, I think you will increase your chance of long term success.