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How often should you rebalance your investment portfolio? Some don’t see a need to rebalance their portfolio ever. Their thinking is: why mess with a good thing? If winners continue to rise, why bother taking those profits and allocating them into lesser-performing stocks?
Let me start off by saying I am advocate of portfolio rebalancing. The primary goal of rebalancing your portfolio is to reduce your risk relative to your targeted asset allocation. Over time, different asset classes result in different returns, changing the portfolio’s asset allocation. In order to recapture a portfolio’s original portfolio asset allocation, the portfolio should be rebalanced yearly.
Some argue that the market is perfectly rational, so why even bother? Here’s the thing about it. Rebalancing smooths investment returns. As you may know, all asset classes go through cycles. There are four main asset class cycles.
During a recovery, risky stocks, such as high-flying tech companies, normally perform very well. In turn, investors are rewarded for taking on additional risk. Stocks during this time period normally greatly outperform government bonds.
In addition, high-yield bonds, also known as junk bonds, outperforms investment-grade bonds, also known as AAA bonds. High-yield bonds can sometimes deliver the highest returns in the asset class.
Depending on who you ask, the US market is either in expansion or about to transition into the slowdown portion of the cycle. During this period, stocks are normally the best-performing asset class due to the acceleration from the economy that causes rapid earnings growth and an increase in profit margins.
High-yield bonds continue to typically outperform investment-grade bonds, while government bonds are the worst-performing asset class because of rising inflation concerns and tightening monetary policy.
This phase is one of the toughest to predict as it makes for an uncertain time for asset-allocation decisions. Stocks and bond markets all deliver roughly a similar performance that is in line with savings account rates, which have risen due to tightening monetary policy decisions.
Finally, during a recession, government bonds are the best-performing asset class as investors become risk averse. In this environment, you will see people jumping out of the stock market and corporate bonds and piling into government bonds.
Source: Fidelity Investments (AART)
A study by the Vanguard Group compared rebalanced portfolios with those that were not, from 1926 through 2009. A portfolio that was never rebalanced started a traditional asset allocation of 60% stocks and 40% bonds. Over time, it became heavily weighted to 84% in stocks and just 16% bonds. For those that are getting closer to retirement, by rebalancing your portfolio, you might be able to reduce volatility by 17%.
So When Should You Rebalance?
According to Vanguard, their findings indicate that there is not an optimal frequency or threshold when rebalancing your portfolio. They state, “This paper demonstrates that the risk-adjusted returns are not meaningfully different whether a portfolio is rebalanced monthly, quarterly, or annually. 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.”
So with that said, I like to rebalance when an asset class weighting has changed by five percentage points. Like dollar-cost averaging, the best thing about rebalancing your portfolio this way is that it removes the timing of the market from the process. As I’ve reiterated before, timing the market is a fool’s game.
I know some experts say to do it monthly/quarterly/yearly. Here’s my thinking. If your portfolio has only moved from 60/40 stocks to bonds to 59/41 stocks to bonds, that’s really unsubstantial. Instead, I’d wait for your portfolio to hit that 5% mark before I change it and then, only annually.
According to this chart from Vanguard, you can see that if you did this that over past 90 years that this would have resulted in a rebalance every three years.
Some may ask why they would want to buy stocks and bonds when they are down. But then I saw this baseball quote from Gary Thayer, of Wells Fargo Advisors: “Not a lot of people hit the ball to right field. But you don’t take the right fielder out of the game.” Makes sense to me.
So are you going to rebalance your portfolio this year? Do you agree with the premise? Share your thoughts below.