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Is Now the Time to Rebalance Your Investment Portfolio?

By Adam Levy - Dec 19, 2020 at 7:45AM

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If you always rebalance at the end of the year, you may be missing out.

Many investors rebalance their investments at the end of the year or at the start of the new year. Some might rebalance more frequently, like the end of every quarter or even every month. 

Rebalancing, no matter how you do it, helps mitigate the volatility of returns in your portfolio. In fact, studies show it makes no difference whether you rebalance annually, quarterly, or monthly. You end up with practically the same returns with minimal impact on volatility.

That said, executing your rebalancing based solely on the calendar is suboptimal. Instead, investors may be better off rebalancing only when their portfolio deviates significantly from their target allocation.

Businessperson balancing stacked coins on wooden seesaw.

Image source: Getty Images.

Maximizing returns, minimizing volatility

Rebalancing only when your asset allocation deviates considerably from targets allows you to take advantage of swings in the market, producing better returns. In essence, you end up buying low and selling high by default.

But you don't want to buy or sell too soon. If stocks are on a bull run, you want to allow them to run up to capitalize on the gains. So rebalancing anytime stocks outperform other asset classes by just 5% or so will have you frequently selling stocks and missing out on further gains.

One study found using a 20% relative tolerance band is ideal for maximizing returns while keeping volatility in check. Allowing portfolios to drift further more often misses buy and sell opportunities rather than extending gains.

In practice, someone with a simple 60/40 stock and bond portfolio would only rebalance when bonds increased to 48% (20% above 40%) of the portfolio or decreased to 32% (20% below 40%). More complicated portfolios with several asset classes can follow the same principle, adjusting for each asset class's relative weight.

Only make a transaction when you have to

Using a tolerance band instead of a calendar ensures you're only making transactions when you have to in order to keep volatility in check. Transactions often come with costs. Whether they're costs charged by your financial institution or taxes on capital gains, it's important to consider the price of rebalancing.

To that end, there are a couple ways to limit the number of transactions in your account beyond using tolerance bands.

The first is only looking at your portfolio often enough. While you don't want to wait too long between each time you check your portfolio to see if it needs rebalancing, you don't need to check it every day. The optimal time between rebalancing checks is two weeks. It's equally as effective as checking every day or once a week.

The second strategy is rebalancing your portfolio only to the point where every asset class moves back into the tolerance bands. Rebalancing a portfolio with just two asset classes is easy, and only requires two transactions every time you want to rebalance. As you expand the number of asset classes in your portfolio, however, you want to avoid having to buy and sell every asset every time you rebalance. 

Only buying or selling the assets that have moved beyond their tolerance bands will keep total transactions low. However, it'll also mean your portfolio doesn't ever exactly match your target allocation. As long as it stays within your tolerance bands, though, it should be good enough to produce the expected returns of your target portfolio while minimizing transaction costs.

Is now the time to rebalance?

If you're used to rebalancing your portfolio at the end of every quarter or calendar year, it might benefit you to check up on your portfolio more often. That doesn't mean you're rebalancing more or less often. It just means you're paying closer attention to what the various assets in your portfolio are doing and taking advantage of the market volatility you inevitably encounter to maximize your returns. As Warren Buffett said, "Keep all your eggs in one basket, but watch that basket closely."

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