Rebalancing Options

Richard Ferri, in All About Asset Allocation, defined rebalancing as “the means by which you get the portfolio back to its original asset allocation target, thereby remaining adequately diversified.” If there is no rebalancing of a portfolio over time, some asset classes will be disproportionately large relative to the others, increasing the risk of the portfolio.

The rebalancing of a portfolio can be done for at least four different reasons, each of which has its own strategy and comes with its own risks. R.J. Shook in Asset Allocation Strategies from America’s Best Financial Advisors* explains the four major rebalancing strategies as practiced by the best investment advisors. Keep in mind that Mr. Shook’s book was written primarily for financial advisors, and that these methods are weapons in the arsenal of good investment advisors. I have paraphrased the explanations so they can of more use for the individual investor and added a few brief additions of my own.

Regular, or “return-to-target allocation.” The most direct and basic reason for rebalancing is to return your portfolio to its original asset mix. The logic of this is simply that different asset classes will perform better than over time, overweighting the portfolio in these asset classes. If stocks were intended to be 60% of a portfolio but become 90% of a portfolio over a ten year period, the portfolio as a whole would become riskier than the investor intended.

There are two rebalancing options available here. The portfolio could rebalanced on a periodic basis, say, once a year. Or it could be rebalanced if a specific portfolio component becomes overweighted by a certain percentage, say 5%.

Strategic needs rebalancing. If there are significant personal or financial changes in an individual’s life, rebalancing might be required. These changes could include the death of a beneficiary, a change in health status of the investor, or a change in the risk tolerance or goals of an investor, among others.

Strategic outlook rebalancing. This type of rebalancing is practiced when the long-term trends of various asset classes, capital markets or other economic and political factors change. Rebalancing is then used to preserve capital, increase returns, or otherwise satisfy an investor’s requirements. It can be seen as a relatively long-term solution to major changes in economic and political events.

Tactical rebalancing. This type of rebalancing is similar to strategic outlook rebalancing and happens over a shorter time period. If done well, it might be called tactical rebalancing; if done badly, it might be called market-timing. A good investment advisor will use experience, intuition, quantative analyses, fund manager and fund analyses, and other means to improve returns or reduce volatility. But many good investment advisors see this type of rebalancing as counter-productive and potentially costly since its runs up costs, fees, commissions and taxes for the investor, requiring even greater returns, requiring even greater risks….

Most individual investors will be using the first strategy—regular, simple rebalancing. And in most cases, an individual investor with a well-planned, well-diversified and well-allocated portfolio will be adequately served by the first simple method, and probably with less risk. If you want more, you can find a good investment advisor that can and will use the other methods and tools that include sophisticated computer models—for a price.

While rebalancing is a necessity for most portfolios, it can be expensive if the portfolio is held in a taxable account. For this reason, simple and infrequent rebalancing would be appropriate, possibly with the advice of a good tax accountant or investment advisor.

There is one good alternative to rebalancing in a taxable account. Simply continue to add money to the under-represented asset classes. For example, assume that a domestic stock and bond split should be 60% stock/40% bond, and it goes to 80% stock and 20% bond. Stop adding the stock portion, and continue to add to the bond portion until the portfolio is back to the desired mix.

For more on rebalancing, see Investment Link Tutorial: Rebalancing.

*From The Winners Circle: Asset Allocation Strategies from America’s Best Financial Advisors, R.J. Shook, Horizon Publishing Group, 2007, pp.136-138.