Four Steps to Rebalance Your Portfolio

If you implemented the ideas behind the last six posts, you have a fair idea about how to put together your personal portfolio policy. In previous posts we’ve talked about rebalancing, but never really addressed the question of how often and how best to accomplish it.

I suggest you look at your portfolio at least once a quarter to see if it is still aligned with your portfolio policy. If you enjoy getting down and dirty with numbers, then a monthly review will work even better. If you really, really hate this, but know you need to do it, then push the odious task out to six-month intervals—but recognize you are probably giving away a bit of your long-term performance.

Rebalancing is a four-step process:

Step 1: Determine the market value of all your investments. These days the market value of most of your investments should be available online. (And I know you can get online because you’re reading this.) Add up all the investments in each bucket of your portfolio policy.

Step 2: Compare the current allocation of your investments with your policy targets. I do this as dollar amounts; some people prefer to use percentages above or below their target. For example if large-cap domestic stocks are supposed to be 25% of your portfolio and that should be $100,000, and they actually are $110,000, then under my approach I would show the large-cap stocks as $10,000 too high. The percentage folks would show it as 110% of target (or 10% over target.)

Step 3: Identify any investments that are significantly higher or lower than your target. Rarely will you be exactly on target, and it takes time (and sometimes money) to rebalance your portfolio. Therefore you need to pick a threshold to rebalance. I choose a dollar threshold, so if the deviation is above that amount, I need to do something; below the limit means I can delay rebalancing that particular asset because the class is not significantly skewed.

Percentage devotees will pick some bracket and say that if the asset stays between (for example) 90% to 110% of target, there is no need to rebalance. Outside of the range, they need to do some buying and selling.

If you are in the investing stage of your life, you can often address your imbalances by deciding where to put new money. Sometimes you are constrained because much of your new investment is going into your employer’s 401(k) plan and you can change your contribution allocation a limited number of times a year.

In any event, the time to decide your rebalancing criteria is when you first set up your portfolio policy. If you wait until later, inertia will cause you to let the rebalancing slip (oh, it’s not too far off the procrastinator says) or fervor will cause you to rebalance more than you need (gosh, large-caps changed 1% today, I’d better fix that imbalance right now!)

Step 4: Decide the most effective way to rebalance. To the extent possible, I try to rebalance in my tax-deferred accounts because those sales do not generate taxes. If you’re a faithful reader of my blog, you know I use mutual funds for equities rather than individual securities [see Risk in Buying Individual Stocks 5/26/2010]. I mostly use index funds with no sales or purchase fees. (The rare exception is an emerging market fund with a low redemption fee.) With bonds, I use an online broker. The idea is to keep the transaction costs as low as possible. As a general rule, the higher the transaction costs, the less frequently you should rebalance because transaction costs diminish the benefits of rebalancing.

I maintain both a Rollover IRA and a Roth IRA. I hold some mutual funds in both accounts because many of them have frequent trading restrictions, meaning I can’t buy sold shares back in the same fund for two months. But if I sell (say) the S&P 500 Index in the Roth IRA and a month later I need to buy some back because of a big price swing, I can do so in my Rollover IRA if I have duplicate funds set up.

If you do want to frequently rebalance, and the repurchase restrictions are a problem, split your assets between two mutual fund companies. As long as you keep sufficient funds in each to qualify for the lowest fees the fund company offers, you can circumvent the repurchase restrictions. For example, you can sell Vanguard S&P 500 shares in December and purchase Fidelity S&P 500 shares in January if necessary.

If you only rebalance quarterly, this whole repurchasing issue won’t be a problem for you.

If you have to rebalance using taxable accounts, keep in mind the tax effects of any sales. Try to sell funds with capital losses or small capital gains; but if you can’t do that, it is better to pay some taxes (particularly at a maximum 15% rate) than to allow your portfolio to become significantly unbalanced.

If you use mutual funds with loads or sales costs, I suggest you consider no-load funds and make any new purchases in them. Over the long-term loads are a shackle on your flexibility and net returns—but that’s a different post.

Whatever route to rebalancing you choose, keep it simple so you can implement and stick with your plan. Better to rebalance only twice a year than commit to doing it monthly and then become sufficiently annoyed at the time and hassle that in frustration you stop rebalancing all together.

Following this approach you will usually end up selling winners and buying losers. For individual stocks that may not be a great plan, but when dealing with widely diversified mutual funds, I think of it as shopping in the bargain aisle and funding my shopping spree by selling off things that are becoming more and more expensive (as the price increases.) Unless you have the will of a mountain, you too will be tempted to hold on to a mutual fund “because it’s still going up.” Keep this in mind: if everyone believed those stocks must go up, they would have already increased in price.

Similarly, sometimes it feels like you are throwing good money after bad as some category falls into disfavor. Do it anyway. If you really feel squeamish, spread your purchase out over a few months rather than making it in one lump.

Financial professors have written a number of papers that show the most important determinant of long-term investment performance is the asset mix. I’d like to add that once you’ve made that all-important decision, the next best thing is rebalancing.

A couple years ago I had a financial advisor compare my personal investment returns to an approach using the same mutual funds utilizing rebalancing only once a year. He reported that in each of the five years my rebalancing policy had beaten the benchmarks. Will that always be the case? Undoubtedly not. A year will come when one asset class only goes up, another only drops—and I kept selling the former to fund the latter. In that kind of year I will not do as well as a strategy that does not rebalance, but none of us knows in advance when that is going to happen. Those who followed the tech stock boom up discovered it cratered much more quickly than it climbed. That’s usually the case for bubbles. If you haven’t been selling on the rise up, it will be too late when the crash comes.

An old Wall Street adage goes something like this: Bulls can make money; Bears can make money; Hogs get slaughtered! (Jim’s caveat is that if you can become the CEO the last statement no longer seems to hold.)

The calendar year is about to end. Isn’t this the traditional time for resolutions? How about reviewing (or creating) your investment portfolio allocation policy and rebalancing if things are out of whack.

~ Jim