Portfolio rebalancing is an important and overlooked process in investment management. Many investors want to run away from assets that have declined in value and chase those that are increasing in value, using emotion to sell at a low and buy at a high.
Some of this is a fear of missing out, wanting to have more of what’s going up in value — and also wanting to avoid further loss by selling what is down. It has some rational appeal, but it causes investors to do the opposite of what they should be doing to maximize long-term performance: buying when assets are relatively down and selling when assets are relatively high.
That’s the key to rebalancing. Rebalancing should be driven by predetermined rules to diminish the negative effects of emotion. Rules-based rebalancing keeps the investor from harming the portfolio’s performance, at least in this one area.
Two Fundamental Forms of Rebalancing
It is also important to distinguish between two fundamental forms of portfolio rebalancing.
We rebalance portfolios based on market performance. An optimized risk/reward relationship is how a portfolio should be structured. As asset classes perform differently in the market, the actual portfolio will drift away from the targeted percentages. By rebalancing, the investor sells a portion of what is over-appreciated in value; and purchases that which has been under-appreciated, selling high and buying low.
There are two rule-based approaches to his type of rebalancing. Investors can choose to rebalance when an asset class deviates from its target by a predetermined percentage. Alternatively, the rebalancing can be done on time, such as at six-month intervals.
A rules-based approach helps keep the investor from chasing returns by over-rebalancing. Not every little swing in the market needs to be addressed; we’re looking to take advantage of trends, not volatility.
The second form of rebalancing is goal based, not market based.
As investors approach significant goals, it is important to reduce risk and keep the attainment of the goal achieved. For example, if the goal is to fund a child’s education. The investor will want to reduce risk in the portfolio as the goal gets closer. Typically this process should begin about five years out. In this case, the rebalancing is to achieve altered portfolio allocations, not to adjust for market conditions.
Use predetermined rules for both forms of rebalancing. The investor should know well in advance what the portfolio allocations will be immediately after rebalancing.
Considerations of Rebalancing
Two major considerations when rebalancing portfolios are taxes and costs. By paying attention to these two factors, an investor can rebalance with a minimum of unnecessary cost.
Selling an asset can have tax consequences. Investors strive to minimize unnecessary taxation.
Two keys to minimizing taxation when rebalancing are to take advantage of the opportunity to rebalance within tax-qualified accounts, such as a 401(k) or 403(b), and to carefully select which assets to sell outside of tax-qualified accounts.
Eliminating taxes may not be possible; the goal should be to pay no more than necessary.
The other major consideration is costs. Some assets will have transaction costs to purchase or sell. By paying attention to transaction costs, investors can achieve their rebalancing objectives without unnecessary costs.
Naturally, taxes and transaction costs are secondary to investment selection. There are limits to how hard an investor should try to minimize costs. It does not help to lose out on investment performance to minimize costs. If an investment isn’t something you want to have in your portfolio, you should determine the best way to get rid of it; don’t hold a dog to save on taxes or fees.
Consider Cash Flow
Investors can also use cash flow to aid in rebalancing. If you’re making ongoing contributions to investment accounts, this can be an easy way to invest into the asset classes you want without incurring any additional transaction costs over and above what you were going to pay anyway.
The Bottom Line
Portfolios deviate from the structures we set up and want to maintain. And we humans are not good at doing what is best for us when it comes to our investments. We bring a host of attitudes and biases that oftentimes do not work in our best interests.
Having a rules-based approach to portfolio rebalancing can help us achieve our long-term goals despite our tendency to investment sabotage. Investing is a proven process of increasing the likelihood of achieving our goals. Rebalancing is an important part of that process.