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INVESTING IS ALL about picking the “best” investments—or so I thought. It took a lot of years to realize that this was the wrong focus. Instead, selecting a portfolio of good, reliable investments and sticking with them is what really worked for me and for my clients.
Sound simple? It can be—but the maintenance is surprisingly hard. We’re talking here about periodic rebalancing. That involves setting target percentages for a portfolio’s various investments and then occasionally buying and selling, so you bring a portfolio back into line with those targets.
As my investment advisory business grew, keeping clients’ portfolios on track was taking a lot of work. That’s what got me interested in rebalancing theory. The article I found most informative was Marlena Lee’s 2008 study, Rebalancing and Returns, which became the basis for our rebalancing policy. From the article, I learned that rebalancing is complicated if you want to get the most from it. These are the questions you need to tackle:
Some investors rebalance according to the calendar, meaning they might check their portfolio every month, every quarter or every year. But Lee’s article suggests a better strategy is to rebalance when a portfolio’s actual asset allocation strays beyond an acceptable limit. This limit is called the “rebalance band.”
The rebalance band is the range around the target allocation that’s deemed acceptable. According to Lee’s article, the rebalancing strategies that produced the highest returns were those that used a 20% rebalance band and looked for opportunities to rebalance every one, five or 10 days.
How might that work in practice? For a simple three index-fund portfolio, we might set these target allocations:
Let’s assume we use a 20% rebalance band, which means we don’t want an investment position to be 20% larger than our target or fall more than 20% below it. That means a trigger event occurs when the actual allocations are outside the following bands:
That still leaves us with the choice of how often to look. Lee’s data indicates it’s preferable to look as often as every trading day to every 10 days. At my firm, we settled on twice per month—roughly every 10 trading days—even though this increased our workload substantially compared to our earlier annual rebalancing.
Next, we were faced with the “what to rebalance” decision. Typically, if you rebalance according to the calendar, you rebalance all investments back to their target allocation. But with band rebalancing, we could rebalance the entire portfolio or just the asset classes that were currently outside their band. We decided to focus on rebalancing only those investments beyond their rebalance bands, though we made adjustments elsewhere if these trades left portfolios with too much uninvested cash or, alternatively, with too little cash to cover upcoming withdrawals.
We were extremely interested in any rebalancing premium. Maybe all this effort could result in better returns. Rebalancing and Returns reported a 0.24 percentage point increase in annual returns if you rebalanced twice a month using 20% rebalance bands, relative to the return you might get with annual rebalancing. Maybe that additional return shouldn’t be a big surprise: Looking twice a month provides more opportunities than annual rebalancing to sell asset classes that are high and buy those that are low.
The good news is, we had settled on a rebalancing policy. The bad news is, we had created an implementation nightmare.
For those of you managing your own portfolio, using a spreadsheet is a good option. But if you’re managing multiple portfolios for friends or clients, looking twice a month is going to be very time consuming. We chose to automate our spreadsheet and, over the years, it got better and faster. A better choice for advisors with 100-plus clients is licensing software. Some vendors include AdvisorPeak, iRebal, RedBlack Software, Tamarac and TRX (Total Rebalance Expert). A fortunate few will find that their custodian provides a free rebalancing tool.
The bottom line: Rebalancing is better than no rebalancing. Rebalancing when a portfolio is “out-of-band” is better than annual rebalancing. Consider using a 20% rebalance band. And looking twice a month for rebalancing opportunities may boost performance.
Rich Chambers is a Certified Financial Planner and the founder of Investor’s Capital Management, LLC. His began his career as a software engineer with IBM before becoming a financial advisor in 1999. Rich is now retired and lives near Lake Tahoe with his wife and their three pooches. He spends time birding and has just finished teaching a class, “Birding by Ear: Bird Sounds of Lake Tahoe.” Contact him via email at richc@advisorinnovation.com.
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Interesting approach. I selected a nominal +/- 5% (vs. your illustration’s +/- 8% and 4%) a few years ago after three decades of 100% equity index funds. I also had a money market fund with a few years of living expenses in it, so technically less than 100%, but it certainly was easy to manage. 🙂
With rebalancing there are taxes and trading costs to avoid, but that’s manageable.
I have a question: I assume you were busier than usual this year due to the volatility, but approximately how often on an annual basis did you find your clients’ allocation bands exceeded to the point where rebalancing was required? In my case of having a bond allocation for the first time beginning 3 years ago, it only happened once: mid-March of course. Thanks!
Edit: Maybe not a relevant question for clients with a small equity allocation?
Same here. After a lot of equivocation I settled on 5% bands applied to total equities, and total bonds. That triggered mid-march. I still question exactly how much to move during a rebalance (vs, say, slightly over-balancing) but for now I just reset my stock/bond percentages straight up.
Very interesting article. I like the idea of setting a bi-monthly calendar alert and checking our assets.
I don’t think my Vanguard stock and bond index funds have ever hit the 20% band since I bought them in 2009. I have been using the 5-10% band to trigger rebalancing once a year.