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I used AI as an editorial assistant to help organize and refine my thoughts; the underlying ideas and personal experiences remain my own.
Rebalancing sounds simple. Pick your target allocation and, whenever a holding drifts too far, trade back to target.
That’s how I thought about it as I started managing my risk portfolio. The problem was that I never stopped to ask what “too far” meant. I found myself reacting to routine market movements that had little effect on my long-term plan. Eventually, I realized the real challenge wasn’t how to rebalance. It was knowing when to leave my portfolio alone.
My first change was to stop thinking of a target as a precise number and start thinking of it as a range. If I wanted a fund to be 20% of my portfolio, there was no reason to trade the moment it reached 20.5%. Markets are noisy. My portfolio didn’t need constant correction.
Later, I came across Larry Swedroe’s rebalancing guideline, often called the 5/25 rule. It says to rebalance when a holding moves either five percentage points from its target or by 25% of its target allocation, whichever comes first. The second part is what appealed to me. A 20% allocation gets a four-percentage-point band, while a 4% allocation gets just a one-point band. Each is allowed to drift by the same relative amount.
That simple idea changed how I think about rebalancing. Instead of reacting to every market move, I now wait until the portfolio has drifted in a meaningful way.
Over time, I learned two more lessons. First, I ignore tiny trades. If the adjustment is insignificant, it’s usually not worth the effort. Second, I let cash flows do as much of the rebalancing as possible. New contributions go to whichever holdings are furthest below target. Withdrawals come from those furthest above target. Often, that restores balance without selling appreciated investments.
Finally, I pay attention to taxes. The same rebalance can produce very different tax bills depending on which account I use and which shares I sell. Whenever possible, I rebalance where the tax consequences are smallest.
I don’t pretend it’s the only sensible approach. But it has one quality I value above all: most of the time, it tells me to do nothing. That’s exactly what I want. A good rebalancing strategy shouldn’t keep me busy. It should keep me disciplined.
In essence, your strategy allows you to sell high and buy low. As long as you keep tax issues in mind, it seems to be a worthy plan indeed. Better yet, it works for you and lets you sleep well at night (SWAN).
This may be naive, but unless your investments are all tax sheltered, doesn’t rebalancing create a tax liability in many cases?
My sort of rebalancing is just to redirect future dividends and interest into different investments. A gradual and limited approach to be sure.
It does sometimes create tax liability – a cost to manage your risk. I try to be tax efficient with my rebalancing to the best of my ability. Yes, redirecting dividends is a good strategy as well to rebalance to your target band.
Rebalancing your portfolio should be about risk management, not maximizing returns. Equities usually outperform fixed income. If you don’t rebalance, the risk will increase. By the way, Larry Swedroe is one of the best personal finance writers around and almost everyone would benefit from reading his books.
If you insist on rebalancing, that’s not a bad approach.
Jack Bogle said, “ Rebalancing is a personal choice, not a choice that statistics can validate.” He wasn’t dogmatically against it — he said if you must rebalance, once a year is enough, but argued that over the long term, the strategy is unlikely to boost returns, and you may end up with taxable gains and trading costs.”
Based on your post, you appear to have taken the taxes & trading costs into account, so continued success.
I long ago stopped trying to pick stocks and have instead only held low cost ETF’s and mutual funds which have, in the aggregate, generated very good total returns over 10+ years. It is also possible to address most of your rebalancing needs by relying on funds with a set equity/fixed asset allocations, e.g. Vanguard’s VBIAX. I also use a handful of other funds in order to gain representation in foreign, high yield, real estate and other asset categories. In order to maintain my target asset allocation, I use a spreadsheet to track overall and category asset allocation. This is especially helpful when you are managing several portfolios (separate property, IRA’s and community property) and want to make sure that your overall asset allocation remains within limits.
If rebalancing means to sell, the best performing assets and buy more of the worst performing assets, that is not a strategy that I understand. Why do you wanna punish your best performing assets? I do believe in dumping the dogs. Anything that I bought that doesn’t perform as well as I expected and don’t expect to perform going forward, I dump. My balancing occurred. (note past tense.) when I was purchasing the majority of my assets. Certain percentage went into investments that I would hold for more than 10 years if they performed as I wanted them to the bulk of the rest, wanted the assets that I would hold for 5 to 10 years. Under five years was for cash heavy holdings. I have been retired for 18 years and I still feel the need to only follow the above advice. The only investments I’m really making today are when I sell off real estate or other holdings.
Yes.
i think it was Peter Lynch that said “don’t pick your flowers and water your weeds.”
if you rebalance too aggressively that is what you end up doing. Lately I have been letting my winners run until they are well over my target.
If I want each stock to count for no more than 5% of my portfolio, I don’t trim until it gets to 10%.
So I’m using more like a 100% rule than a 25% rule; that is working great in this market.
I rebalance among asset classes, not individual stocks.
I only know which assets were the winners in hindsight. At the time I rebalance, I don’t know whether today’s winner will keep winning or when today’s laggard will recover.
This process keeps me disciplined.
I don’t have any better insite into the future than you do but I do know what my past performance has been. When I pick a stock to invest in, I have an expectation as to what return I will get. If that return has been suboptimal for too long, I decide to sell it. On the other hand stocks that have done well for me in the past, I will reevaluate as well, but just because they have become a larger percentage of my portfolio due to their exceptional growth, I’m not ready to sell. One example would be Berkshire Hathaway, I invested in 1982 and it became a very significant part of my portfolio. I liquidated most of it last year. I don’t think it’s a bad investment, but I don’t think it’s going to have the spectacular returns going forward so it is now a much smaller part of my portfolio.
An interesting exchange of thoughts, Bob, Kevin, Randy:
Like you Bob, I too typically would set an expectation for an individual equity before I bought it. (I say “would” in the past tense as I am presently on a journey to reduce my individual equity holdings to 5 or less as I add to my various index holdings). This resulted in a combination of short term holds to multi decade holds, some of which remain today.
With the exception of Berkshire Hathaway, which until now I just included in my Total Market Index % allocation for years as a perennial buy and hold “pseudo” broad index in itself; I made and still make it a point to “take the cream off the top” when an equity exceeds my expectations. These days, I reinvest the “cream” into the various broad indexes I hold in my annual rebalance exercise.
A good case study for “scraping the cream off” vs perennial hold of a good performing stock was GE. I started accumulating GE stock during the halcyon days of the late 80’s and 90’s. I lost count of the stock splits over those years as it went up….until it didn’t starting around 2000. By “scraping the cream” off on at least two occasions during the period preceding 2000 it was a huge help in the downpayment for the first two houses we bought. GE stock met the primary goal I set for it at the time. It was a good example of “let your horses run but corral some of the profits”.
We still hold some of the remaining GE stock to this day. Any other stock that performed as it did after 2000 would have been sold off entirely long ago. GE however was the first stock I ever bought as a newly minted GE employee at the time. It had/still has a little emotional connection. Oddly enough that old GE horse has come back from the pasture and gotten back on the race track in its own right combined its offspring, GEV running ahead of it. I see another round of “scraping of the cream” in the not too distant future after a quarter century of dormancy.
Meanwhile I too am probably going to say good bye to Berkshire Hathaway after multiple decades of accumulation and holding. Berkshire met its purpose/completed its mission and while well done, time to go. I have no emotional connection to it, never have. It will just be ruthlessly indexed soon in my portfolio.
One idea I’ve used… turn off dividend reinvestment. This will allow you to accumulate cash and buy shares in an under allocated investment.
Me, too, Harold. I like that idea. For one, you can still get 3.5% on your cash. For two, I don’t particularly like reinvesting dividends right now at market highs. Building up a little cash feels good and gives you some dry powder to buy on a future dip.
In a non-qualified portfolio yes. Or simply balance using the composite of all your portfolios – qualified and non-qualified.
Nice article! So when you rebalance, do you rebalance fully, all the way to the target allocation percentage, or only to the minimum to get you within the acceptable band? If your desired allocation of 20% drifts to 30%, do you only rebalance down to 24% (which would be your acceptable limit) or all the way to 20%? I’ve heard of people doing it both ways.
I rebalance to the target; otherwise you can find yourself out of balance too often if the position drifts slightly away from target again.
Thank you!
I rebalance to the band rather than target.
Strikes me as simple actionable advice. To make it even simpler, don’t have any allocation targets as low as 4% to anything 🙂
Mark, Thanks for writing this.
I have been using the 5% portion of the rule but had not arrived at the 25% rule for the smaller allocations. I like it! I am going to adjust my spreadsheet formulas accordingly! Very helpful as I have struggled a bit on when to rebalance the the lower allocation elements of the portfolio.
In general I am with you. Make as few and for me infrequent (once, maybe twice per year adjustments). Now I will just let the spreadsheet tell me when the smaller allocations get adjusted without even having to think further on it.
Another nugget collected on the journey to an autopilot portfolio.
Well done and best regards.