Rebalancing Your Portfolio

Last time we discussed implementing a portfolio in a tax and cost-efficient manner. Once this has happened, you should manage, report, and review your portfolio to ensure you are headed in the right direction. Today, we’ll focus on managing of your portfolio.

Even after you have set your investment strategy, it’s easy to veer off course. As the market moves up or down, your current, actual mix becomes different from your target mix. Over time, this could have a negative impact on your returns and result in greater volatility than you intended.

Imagine it is 1995 and you have a portfolio that is 60% stocks and 40% bonds. As you may recall from the good ‘ole days, the stock market grew like wildfire for the next five years, and would have brought your allocation to nearly 80% stocks and 20% bonds. Then, from 2000 through 2002, the stock market lost a cumulative 45%, driving your allocation mix back down to about 60/40. Now, you may think the market rebalanced your portfolio for you, but that is not the case.

If you rebalanced regularly since 1995, you would have kept your exposure to stocks in check over the ensuing eight years, thereby reducing your risk. Just as important, you would have increased your annualized return by a full percentage point. That may not sound like a lot, but on a $1 million portfolio, rebalancing would have added about $100,000 to your portfolio over the eight years from 1995 through 2002. In addition, if you calculate the numbers through 2008, your portfolio would have been worth nearly $200,000 more.

So, how do you effectively rebalance your portfolio? The best way is to use a disciplined, systematic approach. Once your targets for each asset class are set (see my earlier blog on design), you should set trading thresholds around each target. A common approach would be a movement of plus or minus 20% of the target amount. For example, if your target allocation is 10% to small caps, if it fell to 8% or grew to 12%, it would trigger rebalancing. If it grew, you would take the 2% in “extra” proceeds and redistribute it to another area of the portfolio that may have fallen below target. If it fell, look for another area of your portfolio that has grown past its target and rebalance accordingly.

It sounds simple, but it’s not that easy. Remember, your portfolio may comprise multiple accounts with different tax treatments, and you may be selling in one and buying in another. Refer back to my “implementation” blog, where I discussed asset location and the problems of having too many custodians. In general, the fewer the custodians and the fewer the accounts, the easier it is to rebalance. If you are proficient with Excel, a spreadsheet may help you keep track of all the necessary trades.

With regard to how often you should rebalance, for the most part, the numbers should determine it. Rebalancing should not be triggered by the passage of time, but by thresholds and the opportunities a volatile market may present. The more volatility, the more often you should check for rebalancing opportunities. Keep in mind that rebalancing triggers trade costs and can trigger taxes. So, it is important to figure into the process how these costs and taxes affect the benefits of rebalancing. Too large a tax bite for a small rebalancing might sway your decision.

To sum up, check often but trade infrequently. This process will keep you disciplined, can increase your return and can reduce your risk.

In the next blog, we’ll discuss the next stage of managing your portfolio: measuring your performance and reviewing your strategy.