Best Practices for Portfolio Rebalancing

by Francis M. Kinniry Jr. , Colleen M. Jaconetti and Yan Zilbering

Best Practices For Portfolio Rebalancing Splash image

The primary goal of a rebalancing strategy is to minimize risk relative to a target asset allocation, rather than to maximize returns.

It is well documented that a portfolio’s asset allocation is the major determinant of a portfolio’s risk-and-return characteristics (assuming a well-diversified portfolio that engages in limited market timing). Yet, over time, asset classes produce different returns, so the portfolio’s asset allocation will likely drift. Therefore, to recapture the portfolio’s original risk-and-return characteristics, the portfolio should be rebalanced.

Many investors ask “how often, how far and how much” to rebalance a portfolio. Similar to the initial selection of a portfolio’s target asset allocation, the selection of a rebalancing strategy involves a trade-off between risk and return. In theory, investors should choose a rebalancing strategy that weighs their willingness to assume risk against expected returns net of the costs of rebalancing—including time, taxes and labor.

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Francis M. Kinniry Jr. , CFA, is a principal in the Vanguard Investment Strategy Group.
Colleen M. Jaconetti is an senior investment analyst in the Vanguard Investment Strategy Group.
Yan Zilbering is an investment analyst in the Vanguard Investment Strategy Group.


Discussion

Lewis from New York posted over 2 years ago:

klkklk


Ron from Texas posted over 2 years ago:

Very helpful. I have intended to use "volatility pumping"; i. e., rebalancing, to increase returns, but in practice it has been psychologically hard to sell winners and buy losers. Now I see that I should relax and enjoy making relatively small, infrequent adjustments. Re-allocating cash flows instead of simple reinvestment also has some practical benefits, especially in taxable accounts where multiple small investments create complications at tax time.


Art from California posted over 2 years ago:

It's worth reading the original Vanguard study referenced in the article. Besides the 1926-2009 results, its appendices show the more recent 1989-2009 results for all the rebalancing strategies.

When you compare the full 1926-2009 results with the more recent results one thing jumps right out: over the longer time interval, rebalancing leads to about 0.5% less annual return than "buy and hold"; but over the more recent 20 years, rebalancing gives you about 0.5% MORE annual return.

It's evident why this occurs - the longer time interval includes an overall bull market which we may not see again, so rebalancing hurts you by forcing you to give up some gain; the more recent years include more up-and-down, and when you have this kind of volatility, rebalancing actually increases your overall return compared with buy-and-hold.

The authors believe that the principal goal of rebalancing is to minimize tracking error. However, their data clearly shows that an additional benefit is reduced volatility. And, if you believe that the 1989-2009 data more accurately reflects our immediate future than the 1926-2009 data series, yet one more benefit is increased overall return - due to the forced "sell high, buy low" procedure imposed by following a consistent set of rebalancing rules.


Owen from California posted over 2 years ago:

This article is very helpful with good practical information. However, there is one key point that is unclear, at least to me. How is a "10% threshold" interpreted? If my asset allocation goal is 60% stock, does the "10% threshold" for rebalancing kick in when my stock allocation hits 70% (and 50%) or does it kick in when my stock allocation hist 66% (and 54%)? The later is 10% of my allocation goal.


Nola from California posted over 2 years ago:

Yes, Owen, 10% threshold for a 60% target means to rebalance when that asset class hits 54% or 66%.......This is clear if you consider that a real-life portfolio would have more asset classes.......Thus if your portfolio had 10% allocated to REITs, you would rebalance at 9% or 11%.....Nothing else would seem to make sense.


JP from Michigan posted over 2 years ago:

I concur Owen, while I agree with Nola's interpretation, your point should be clairifed in the article. I rebalance using a percentage based on the approximate standard deviation of the underlying asset class. For example, my rebalancing trigger for stocks/REITs/commodities is 10%, while my trigger for bonds is 6%. This stradegy permits riskier more volatile assests to appreciate--or depreciate--more before buying or selling them. Furthermore when rebalancing, I first address inbalances between asset classes, then correct inbalances within an assest classes. When rebalancing within an assest class I use up to two times the standard deviation as "the trigger."


Richard from Illinois posted over 2 years ago:

RPG 516:

Maybe one of you can answer this: What about "Reverse" Rebalancing. At what point do you sell some of your bond holdings to get back to your target allocation? How far down do you wait for the market to go before you sell bond holdings and re-allocate to stocks. Would you wait until your stock portfolio fell to 40% or less of your total portfolio (assuming a normal stock allocation of 60%) before acting. And if you do this, what happens if the market continues to sell off? Then what do you do? Sell more of your bond portfolio to re-allocate? I would appreciate your thoughts. Thanks.


Dave from Washington posted over 2 years ago:

I think if you want to rebalance a 60/40 stock bond portfolio, just buy a target date fund of the appropriate year and be done with it. There are some pretty decent ones out there.



Art from California posted over 2 years ago:

All the studies, including the Vanguard study quoted, show that it doesn't matter much what rebalancing rule you follow, so long as you follow it through thick and thin. Suppose that you have chosen 60/40 stock/bond allocation, and decided to rebalance when your allocations are 10% off target. Then if the stock market is falling, when the stock share gets down to 54%, you sell some bonds and buy stocks to bring it back to 60%. If it keeps dropping, you do this again. We did this during the 2008 crash. This forces you to buy more and more stocks as they fall, so you are having faith that they will come back. Takes a strong stomach, which is why you have to be very careful when you first choose your allocation %s. Then as the market rises, you'll make profits in those stocks, and each time the stock percentage hits 66%, you sell off to bring it back to 60%. If you follow this through a few up and down cycles, the rebalancing, besides forcing you to sell high and buy low, and besides protecting you against too much exposure, actually earns you a little bit more than just buy-and-hold.


Chris from New Jersey posted over 2 years ago:

I strongly recommend analysis before considering a target date fund...I have been researching and analizing (and was in one for a few years). One case in point is that many Target Date funds (TD's) are funds of funds (multiple layers of expense ratios). Another is the "real" mix of stocks and the deviation from intended allocation that's permitted. Using Model Portfolios to check the returns will show some glaring differences. Set up your own "Target Date" model portfolio and track it against some TD's...you'll agree after a short while.


D. from Maryland posted over 2 years ago:

These studies ignore the possible economic benefits of tax loss harvesting.


David from Maryland posted over 2 years ago:

I'm going to go about this backwards, and post my comment first, read the article and see if I changed my mind. About 9 years ago I narrowed my choice of fund families down to Vanguard or T Rowe Price. The reason I chose Price was that they will automatically rebalance for you. That way I could avoid the temptation of letting winners ride or cutting losses early. Vanguard is an index-oriented shop so they don't need to offer the same service. Their clients feel smart when the name of the game is "beat the index and benefit through lower costs." Nothing against them...I have some funds there as well, but it is a very distinct business model.


Karen from Illinois posted over 2 years ago:

So my question is how detailed can this rebalancing thing get? I understand the old 60/40 stock/bond split but within each of those you can have loads of different categories each with it's own dartboard % allocation. Starts getting dizzying to be rebalancing without gettting overwhelmed.


Lincoln from Illinois posted over 2 years ago:

It appears that Messrs. Jaconetti, Kinniry and Zilbering make much to-do about very little in their analysis of "Best Practices for Portfolio Rebalancing" in the May 2011 edition of the AAII Journal. Looking at the results posted in Table 1 (page 26), the differences in average allocations, average annualized returns, and volatility are so small that one wonders if there is any true statistical differences between the proposed strategies. Did anyone look at that? Of course, there is one strategy with a distinctly different set of results: never rebalance! While that strategy ends with a skewed allocation heavy on equities, the return is higher than any of the other strategies at a "cost" of higher volatility. That would seem to underline Mark Hulbert's conclusion in the just proceeding article, "Think Twice, Even Thrice Before Trading" (or rebalancing), where he concludes, "that the average transaction lowers portfolio returns." The data of Jaconetti, et al. seems to substantiate that conclusion.


James from Ohio posted over 2 years ago:

I found the Jaconetti, Kinniry, and Zilbering, article entitled ”Best Practices for Portfolio Rebalancing” in the May 2011 issue of the AAII Journal interesting.

Actually, I found what they didn’t say to be more interesting.

First, they did not say that rebalancing is a good idea, in particular, they did not say that it significantly reduced risk. They merely addressed issues that investors raise who had already decided to use rebalancing.

Second, while they said “the asset allocation decision [that is, the target allocation – JG] is the most important decision in the portfolio construction process,” their article doesn’t provide results for allocations other than the 60%/40% split between stocks and bonds. (I skimmed their original article on this subject that was published in July 2010 and referenced at the end of the AAII Journal article. It didn’t address other allocations, such as 70%/30% and 80%/20%, either.) - - - By inference, the authors have implied that there is no optimal rebalancing frequency or threshold for these other target allocations either.

Third, the authors don’t offer any facts (or even opinions) to substantiate that the reduction in risk from rebalancing (a standard deviation of returns of 12.1%) and the “never” rebalance option (14.4% standard deviation) was significant. Indeed, presuming the distribution of annual returns for rebalancing is normal with an average annual return of 8.67% (the average from the tables in the article) and a standard deviation of 12.1%, we would expect a loss in 23% of the years. (In their July 2010 article, the authors say that the stock market lost money in roughly 25% of the 84 years from 1926 through 2009.) However, using the 9.1% average annual return and the 14.4% standard deviation for the “never” rebalance option indicates an investor would have lost money in 26% of the years. - - - The difference between 23% and 26% is probably something that most investors could not have detected at the time it was happening. In other words, the value that rebalancing provides in reducing risk is small, if not insignificant.

That raises the question “What would an investor have given up in returns by rebalancing in order to achieve that small reduction in risk?” Well, if a person had initially invested $100,000 at the rebalancing 8.67% average annual return for 40 years (a reasonable length of time for a long term investor), he would have ended up with $2.7 million. If he had made the 60%/40% allocation on the initial $100,000, but “never” rebalanced, he would have ended up with $3.2 million. If he had initially invested 100% of his money in stocks and “never” rebalanced, he would have achieved a 9.93% average annual return (the authors’ number from their July 2010 article), he would have ended up with $4.4 million.

My conclusion is that rebalancing offers only a small reduction in risk, but a large reduction in returns over the long term.

Jim Grant
Solon, Ohio
AAII Life Member


Philip from Colorado posted over 2 years ago:

I find it refreshing to see thoughtful commentary from readers who are willing to challenge the assumed benefits of rebalancing as Lincoln and James have done above. If, as the authors admit, risk-adjusted returns are not meaningfully different regardless of rebalancing frequency, one has to question its basic premises. Sure, rebalancing has a certain intuitive appeal, but when average annual returns are shown to be highest for those portfolios that were NEVER rebalanced (Table 1), a discussion of that finding with associated standard deviation and cost savings considerations would have made for a far more interesting article.


Dave from Washington posted over 2 years ago:

Hopefully it's well known that re-balancing is not a way to increase returns, as the author points out in the very first sentence. However, I am currently testing an alternative re-balancing strategy as outlined in an article from the "Computerized Investing" portion of this site. This is basically a value averaging scheme (as oppossed to dollar cost averaging) and can be basically used whenever you are adding new money into the account and IS a way to improve results.


David Mann from Wisconsin posted about 1 year ago:

This discussion appears to be primariliy directed to the accumulation phase. It would be interesting to look at this data in light of those us retired and living off our nest egg at a 4% withdrawal rate on a total return portfolio.


Ferdinand Wieland from Delaware posted about 1 year ago:

I found that one of the greatest benefits of re-balancing is to take the "emotions" out of the decision making, avoiding to buying and selling at the wrong time and thereby improving the "actual investors" returns. Morningstar offer a great tool to compare investment return with actual investor return.

Simple re-balancing assumes that portfolio investment holdings continue to perform; however, it may become necessary to replace non-performing assets. I may be prudent for investors to consider monthly portfolio reviews - ie how did each portfolio holding added or detracted from target results. Supposed, each individual investment holding has been bought for specific purpose such as stable income, capital appreciation etc -- still on target with original goal? Just re-balancing a portfolio which includes "dogs"
may not lead to expected returns.

Could your experts please elaborate on this topic since it is not clear if the presented statistics assume no change of investment holdings within the portfolio. Thanks


Jim Moore from Alabama posted about 1 year ago:

with bond yields at historic lows and a reversion to the mean coming sooner than later does it make since to hold a 40% bond position?


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