Guidance

RESOURCES TO HELP SHAPE YOUR FINANCIAL FUTURE

Reams of academic data show that periodically rebalancing a portfolio back to its target allocations is one of the simplest ways to lower the risk of your investments without doing significant harm to your portfolio’s return potential.

But how often should you rebalance? The answer is less clear-cut. On the one end of the spectrum are investors like David Swensen, manager of the Yale endowment, who rebalances the Yale portfolio every day. That is fine for big institutional investors such as those who manage university endowments, which do not pay taxes on their investment gains and pay razor-thin commissions on their trades. But frequent trading is apt to make less sense for smaller investors. Not only are trading costs likely to erode whatever investment benefit smaller investors might derive from frequent rebalancing, but such an active rebalancing plan also requires a sizable time commitment.

For that reason, investors are cautioned to take a hands-off approach to monitoring and rebalancing. After all, if you are checking in too often for asset-class shifts, you may also run into other tweaks you would like to make, such as adding a little bit of extra cash to that manager who seems to be on fire or tipping some money into that new commodity exchange-traded fund you have been eyeing. A better approach, is to do a top-to-bottom portfolio review, including a check of asset allocation versus targets, just once or twice or year, then make changes only when your allocations to the major asset classes rise or fall 5 or 10 percentage points from your targets.

A Vanguard study adds some research rigor to that guidance. After looking at a variety of different rebalancing scenarios for a 60% stock/40% bond portfolio from 1926 through 2009—including rebalancing monthly, annually, or quarterly and rebalancing when asset allocations hit certain thresholds—researchers Colleen Jaconetti, Francis Kinniry, and Yan Zilbering ultimately conclude that a hybrid approach represents a solid strategy for many investors. Specifically, their work posits that monitoring a portfolio annually or semiannually, then rebalancing when the current asset-class weighting veers 5 percentage points from the targets, strikes the right balance between risk reduction and cost control. Not surprisingly, the portfolio that was never rebalanced had the highest level of return—as a result of its rising level of stocks in an 83-year period in which stocks beat bonds—but its volatility also was much higher than portfolios that were rebalanced periodically. Frequently rebalanced portfolios had the lowest risk without a big return give-up, but the costs of the frequent changes cut into returns.

Those guidelines are very useful, but finding the right frequency for your rebalancing program is a personal decision that rests on a number of factors, including where you are in your investing life and the tax status of your investments. Here is an overview of what to bear in mind.

Tax status of your investments
Rebalancing involves peeling back on your winners, which in turn could result in taxable capital gains if you are selling within your taxable accounts. That calls for erring on the side of less-frequent rebalancing if the bulk of your assets are in taxable accounts. (Those with a lot of assets in taxable accounts should also aim to take maximum advantage of tax-loss selling.) On the flip side, if you hold most of your money in tax-sheltered accounts such as 401(k)s and IRAs, the tax costs of rebalancing are not a concern. The same holds if you are rebalancing within taxable accounts but can afford to restore your portfolio to its asset-allocation targets by adding new money rather than selling.

Time commitment
It is stating the obvious, but a more frequent monitoring and rebalancing approach requires a greater chunk of time than a laissez-faire tack. If you are retired and have the time to commit to more frequent oversight—and will not incur tax and transaction costs to rebalance—it is OK to be more hands-on. Conversely, if you do not have time to give your portfolio any more than the periodic anxious thought, it is fine to check up annually and tolerate higher divergences with your target allocations.

Time horizon/risk tolerance
The key benefit of rebalancing is in the realm of risk reduction, not in returns enhancement. By extension, it stands to reason that investors with shorter time horizons and more limited risk tolerance will want to tightly police their asset allocations versus their targets. Longer-term investors, meanwhile, can safely employ a more hands-off approach that involves rebalancing when allocations veer 5 percentage points (or even more) from their targets.

 

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