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What is Portfolio Rebalancing?
Portfolio rebalancing refers to resetting your investment portfolio back to your intended asset allocation. Rebalancing can refer to restoring the asset allocation to each asset class, ETF or even individual stocks. It can occur at a pre-decided time interval (quarterly, bi-annual or annually). The purpose of rebalancing is to improve returns, and reduce risk and volatility.
Rebalancing forces the investor to purchase investments at a discount (when they are underperforming) and sell overperforming assets. It goes against our natural inclination to hold on to (and buy more “Winners”, right before they crash.
A predetermined percentage deviation from the intended asset allocation can trigger an investor to rebalance. If an intended asset allocation was 50% stocks, 50% bonds, the investor may rebalance once either stocks or bonds reaches 60% of total investments. The purpose of rebalancing is to reduce risk and volatility.
You now have to decide on a rebalancing strategy.
Is Portfolio Rebalancing a Good Idea?
In Vanguard’s white paper, average annual returns over 90 years of back testing were as follows:
- No Rebalancing 8.74%
- Monthly Rebalancing 8.39% (rebalanced if met threshold of 10% deviation from asset allocation)
- Quarterly Rebalancing 8.26% (rebalanced if met threshold of 10% deviation from asset allocation)
- Annually 8.20% (rebalanced if met threshold of 10% deviation from asset allocation)
This does not tell the whole story. Volatility affects investors emotions, and risks them selling at the bottom of a bear market, locking in losses. The timing of your need to draw down your portfolio also will dramatically affect whether you would have benefitted from rebalancing.
Volatility also has a direct effect on cumulative investment returns.
The annualised one listed above is an average of annual returns. The problem is, volatility reduces the actual returns received.
Take this fictitious example of two companies – one making dog jackets, the other dolls. The dog jacket company has stable and consistent 5% growth every year for 10 years. The doll company is far more volatile. Some years have great returns, others are negative. The average return overall is 5% for this company too.
Disclaimer – In case you hadn’t guessed, I have no idea of the investment potential of a dog jacket or doll company!
Investors who invested in the dog jacket company and held for 10 years have significantly more cumulative growth than investors in the doll clothes company.
|Year||Dog Coats R US|
|$10,000 invested in|
Dog coat company
|$10,0000 Invested in |
This seems counterintuitive. But to recover a 50% loss in your portfolio the following year, you need an annual return of 100% (not 50%). The effect of volatility and compounding is captured with an annualized return, calculated using a “geometric average”.
Does Portfolio Rebalancing Improve Returns?
Vanguard tested several rebalancing scenarios. The full white paper is here. They compared the effect of rebalancing on a 60:40 stock: bond portfolio. They back tested data over 90 years in several scenarios to compare returns and volatility:
- No Rebalancing
- Monthly Rebalancing
- Quarterly Rebalancing
- Annual Rebalancing
As you can see from the lower graph, there is a slight improvement with quarterly rebalancing over no rebalancing over a 90 year period. There was minimal difference between returns for the monthly, quarterly and yearly rebalancing schedules.
Most of us don’t have 90 years to invest. Poor performance in the early years of drawdown can dramatically damage your portfolio longevity. This is known as “Sequence of Returns” risk. At times the unbalanced portfolio outperforms the balanced, at other times it underperforms. You can see from the graph above why many early retirees in 2008 had to go back to work.
A 60:40 stock: bond portfolio may be considered very conservative among readers A factor in the good long-term performance of the unbalanced portfolio in Vanguard’s white paper may be that over time the portfolio became more heavily weighted towards stocks, giving the investor a more aggressive portfolio over time. The end unbalanced portfolio would be far more aggressive, and be expected to perform better over the long term. Those with a more aggressive portfolio may find the benefits of rebalancing more significant.
Rebalancing makes sense. Why make an asset allocation at all if you aren’t going to stick with it?
How Portfolio Balancing Works
There are three main approaches to a portfolio rebalance strategy
1. Rebalancing Portfolio with New Money
During the accumulation phase of investing, the most cost effective way of rebalancing is to add funds to the underperforming asset.
If your 60:40 investment portfolio has become 70:30 stocks : bonds, your next investment will all go to bonds. This works well in the early phases of investing. But, as your portfolio grows, growth will dwarf your contributions (hopefully). If you have a million dollars invested and invest $1000 per month, you would never achieve a portfolio rebalance with this method.
With Pearler*, your account can be set up to automatically add your next investment into the lower performing asset, rebalancing each time without additional cost. Sign up for a free brokerage credit* through Aussie Doc freedom.
2. Selling Performing Assets, Buying more of the Underperformers
Once your portfolio reaches a certain size, you will have to sell and buy assets to rebalance. Unfortunately, both buying and selling assets costs brokerage fees. Fees eat into returns. Minimising fees is a powerful way to boost your portfolio performance.
Optimising your rebalancing schedule to maintain a reasonable asset allocation whilst minimizing fees is important. Most sources suggest rebalancing every year, and only if the asset allocation has deviated 5-25% from the plan.
Another strategy is to rebalance within superannuation. It makes little sense to me to ignore your investments inside super. This is still your real money, even if you can’t get to it for several decades. Invest outside superannuation to fill the gap, but approach asset allocation and rebalancing by looking at all your investments as a whole. Rebalancing your overall exposure within super is more cost and tax effective.
For those with a Self managed super fund this is pretty simple. For those of us in industry funds, choices are a little more limited. Some offer a “Self invest” option, but examine the fees carefully. Otherwise, adjust your asset allocations within super to roughly rebalance your overall portfolio. Note the set up and ongoing costs of a SMSF are significant, and not worthwhile for many.
3. Retirement Portfolio Rebalance Strategy
The opposite of the first strategy. Withdrawals are made preferentially from the highest performing asset. Initially, with a high portfolio balance, this is likely to be inadequate. But withdrawing from the winning asset will reduce brokerage costs of rebalancing with strategy 2.
When Should You Rebalance Your Portfolio?
There are 3 approaches to consider:
1. Time Based
Every year, as long as assets have deviated more than 5-25% from the intended asset allocation. This is easy and involves minimal emotion. So set a date such as your birthday, new year or tax time and check your portfolio. Adjust as required
2. Rebalance when there is a Significant Market Movement.
This involves monitoring the market, and rebalancing during a time of stress. Logging into your account during a major bear market risks panic and emotional decision making. In March 2021, the brief but dramatic COVID bear market had almost correctly corrected within a few weeks as long as you hadn’t sold. Selling the losers at this point locks in the losses. Experienced and professional investors may be able to use this and keep a level head. I ban myself from logging into investment accounts during a crash!
Active rebalancing also involves extra costs. Selling winners means you are crystallizing winners. High income earners generally want to defer income until they are no longer in a high tax bracket. Selling means you will have to pay tax on the gains, even if you are simply recycling the funds back into another investment. On top of that buying and selling assets cost brokerage fees. These are good reason to rebalance infrequently (yearly or even two yearly). They are also good reasons to optimise your purchases to keep investments inline as much as possible. Check out Pearler’s automated investment option with automatic rebalancing.
3. A Mixed Approach Combining the Two Above Approaches.
Many will review and rebalance at a set date but also if there are significant market movements. I try not to watch the market too closely (I’m working on it, OK?). But it’s almost impossible to avoid hearing about a significant market correction. So, my own easy strategy is to review and rebalance yearly, and invest extra during significant corrections. Corrections >20% are anxiety producing. Every news outlet and social media channel is screaming that the sky is falling. Working extra shifts and shovelling money into the market gives me something to focus on!
Asset Allocation Changes with Age
Asset allocation may need to change as you get older, or once you hit your goals. As you get older, investors can tolerate less risk. If you have already hit your goals, you don’t need to take as much risk.
This is different from portfolio rebalancing. Instead, this is a review every 5 years to assess whether your asset allocation is still appropriate. Reviews should be performed whilst the market is dull, and you are calm. They should be scheduled and this schedule followed to avoid disguising a speculative interest in a new asset as “reviewing your asset allocation”.
Portfolio Rebalancing Pros and Cons
|Reduced volatility||Brokerage costs and tax on capital gains eat into benefits|
|Optimises return for level of risk appropriate for investor||Complexity increases with investments inside and outside superannuation and property investments|
|Encourages you to buy assets at a lower price and sell at a higher price||Miss out on gains if rebalance part way through a bull run|
|Involves checking your account and risks emotional decision making|
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Aussie Doc Freedom is not a financial adviser and does need offer any advice. Information on this website is purely a description of my experiences and learning. Please check with your independent financial adviser or accountant before making any changes.