Best Practices for Portfolio Rebalancing
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.
In this article
- Theoretical and Practical Considerations
- Trade-Offs in the Rebalancing Decision
- Results of Rebalancing Strategies
- Implementing a Rebalancing Strategy
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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.
Using broad U.S. stock and bond market data from 1926 through 2009, we at the Vanguard Investment Strategy Group found that there is no optimal frequency or threshold when selecting a rebalancing strategy. Our analysis demonstrates that the risk-adjusted returns are not meaningfully different if a portfolio is rebalanced monthly, quarterly, or annually; however, the number of rebalancing events and resulting costs increase significantly.
As a result, we conclude that for most broadly diversified stock and bond fund portfolios (assuming reasonable expectations regarding return patterns, average returns and risk), annual or semiannual monitoring—with rebalancing at 5% thresholds—is likely to produce a reasonable balance between risk control and cost minimization for most investors. Annual rebalancing is likely to be preferred when taxes or substantial time/costs are involved.
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Colleen M. Jaconetti is an investment analyst in the Vanguard Investment Strategy Group.
Yan Zilbering is an investment analyst in the Vanguard Investment Strategy Group.