Portfolio Rebalancing: A Reminder on Why We Do It

Portfolio Rebalancing: A Reminder on Why We Do It

Disclaimer: This article contains information that was factual and accurate as of the original published date listed on the article. Investors may find some or all of the content of this article beneficial but should be aware that some or all of the information may no longer be accurate. The information and/or data in this article should be verified prior to relying on it when making investment decisions. If you have any questions regarding the information contained in this article please call IFA at 888-643-3133.

Portfolio Rebalancing: A Reminder on Why We Do It

As we come to the end of the year, many clients may be wondering whether or not there needs to be action taken within their portfolio. Some asset classes, like International/Developed Small Cap stocks, have done quite well year-to-date, while others, like Emerging Markets Value, have not done so well. We felt compelled to remind clients the thought process behind rebalancing a portfolio and maybe dispel some of the common “rules of thumb” that many clients believe are standard rebalancing protocols.

Quick Review

Just to quickly review, rebalancing a portfolio is the process of adjusting your current allocation back to its target allocation. For example, someone who is currently invested in IFA Index Portfolio 50 has a 50% target allocation towards bonds. If the stocks have had an extremely good year, the investor’s portfolio has probably shifted to more of a 60/40 stock/bond split or even a 70/30 stock/bond split. While great returns are something to be excited about, it also exposes an investor to increasing risk. To provide some perspective, from March 2008 to February 2009, IFA Index Portfolio 50 lost approximately -25% during that time. IFA Index Portfolio 70 lost approximately -35% during the same time. A particular client might be very uncomfortable with losing over a third of their portfolio in a short amount of time. You can see in the chart below the range of monthly rolling one year annualized returns across the IFA Index Portfolios over the last 50 years.

(see the dynmatic version of the chart)

We do not know with any certainty when we can expect these large downswings to occur, but when they do, we want to make sure that our investor’s risk capacity is properly aligned with their risk exposure. Not having these components in proper alignment may lead to more devastating financial consequences as pushing an investor’s capacity to handle losses in their portfolio beyond what they can may lead to an emotional sell-off, thus locking in their losses and missing out on what has historically been shown to be a subsequent recovery. For someone who is close or near retirement, this can have very real effects on their potential standard of living in retirement.

Purpose of Rebalancing

Therefore, rebalancing should be seen as a risk mitigation process rather than a maximize expected returns process. If a client wanted to maximize returns, then they should invest in an all equity portfolio. But once we introduce risk aversion, the focus needs to shift to accommodate the aversion versus maximizing returns. The risk in this case should be understood as deviation from a target allocation. As part of our overall financial planning process, we make certain assumptions on expected returns and risk over different time horizons. These estimates are based on target allocations that are rebalanced (in theory) annually. Likewise, we want to keep an investor’s portfolio close to this target allocation so we can realize the expected return that we used in our modeling and planning process as allowing a portfolio to drift creates different risk and return expectations that are not in alignment with an investor’s overall financial goals.

Now rebalancing a portfolio involves costs. There are transaction costs and taxes that are incurred by investors. There is also the cost of time by IFA support staff to periodically review the thousands of portfolios that we manage. This cost is built into the management fee. A good rebalancing process has a healthy respect for these costs and balances them against the risks that we mentioned above in terms of portfolio drift. There is no such thing as optimal, but something that is reasonable.

The Tradeoff

A recent study published by The Vanguard Group Inc., attempted to establish a reasonable rebalancing strategy by quantifying the average annualized return and risk of two simulated portfolios for the period 1926 to 2014. Both have a 50/50 stock/bond allocation of global stock and bond indexes, but one is rebalanced annually while the other is never rebalanced. From 1926 to 2014, the two portfolios ended up with the following characteristics:

  Annually Rebalanced Never Rebalanced
Maximum stock weighting 60% 97%
Minimum stock weighting 35% 27%
Average stock weighting 51% 81%
Final stock weighting 49% 97%
Average annualized return 8.1% 8.9%
Annualized volatility 9.9% 13.2%

As you can see, the never rebalanced portfolio produced a higher average annualized return over the annually rebalanced portfolio (8.9% vs. 8.1%), which should be expected given its 81% average stock weighting versus 51% for that of the annually rebalanced. But this higher average annualized return was accompanied by 33% more relative annualized volatility (13.2% versus 9.9%). The tradeoff between annually rebalancing and never rebalancing, as in Vanguard’s example, can be understood as a 10% increased in average annualized return for 33% more volatility.

Another way we can possibly understand this tradeoff is the potential for downside loss. You can see that the maximum stock weighting for an annually rebalanced portfolio was 60% versus that of 97% for the never rebalanced portfolio. Although Vanguard never reported these numbers, we can use our own data from our own IFA Index Portfolios to extrapolate potential downside loss based on the 87 year 10 month period from 01/1928-10/2015.  The maximum one-year loss based on monthly rolling periods was from July 1931 to June 1932. IFA Index Portfolio 60 lost -47.53% while IFA Index Portfolio 97 lost -69.58%. The second biggest loss in any given 1-year time span based on monthly rolling periods was March 2007 to February 2008. During this period, IFA Index Portfolio 60 lost -29.70% versus IFA Index Portfolio 97, which lost -47.97%. These represent two very different aversions to risk. Two different investors with two different capacities for risk will act differently during a period such as this.

When Should We Rebalance?

Deciding when to rebalance is crucial when thinking about the tradeoff between risk management within the portfolio and the costs associated with rebalancing. One of the common assumptions is that rebalancing is associated with time. For example, an investor may believe that their portfolio will automatically be rebalanced at least once per year. While this may seem reasonable, we are forgetting that deciding when to rebalance is independent of time. Taking the thought process to one extreme, let’s say that we just rebalanced client’s portfolio at the end of a particular year. Now let’s also assume that this year as been essentially flat (not far from the truth), rebalancing a client’s portfolio is really going through a process of incurring somewhere in the range of $200-$500 in transaction costs and potential short term and long term capital gains for no real benefit. Again, deciding when to rebalance needs to be a balancing act of potential risk exposure within the portfolio and these very real costs that investors may incur.

Vanguard examined three different simulated rebalancing strategies based on a portfolio that had target stock/bond split of 50/50 from 1926 to 2014. These strategies included: “time only,” “threshold only,” and “time and threshold.” The frequency of rebalancing included monthly, quarterly, and annually, and the thresholds included 1%, 5%, and 10% deviation from overall stock/bond target allocation, which in their case happened to be 50/50. Based on their results, Vanguard concluded, “that for most broadly diversified stock and bond portfolios, annual or semiannual monitoring, with rebalancing at 5% thresholds, produced a reasonable balance between risk control and cost minimization.”


Introducing risk aversion into the investing equation shifts the overall focus from returns maximization to risk management. This risk can be viewed in terms of deviation from a target allocation we based our financial planning assumptions on or downside volatility, which may force investors into uncomfortable environments. Rebalancing is a process implemented by our Portfolio Management and Research Department to assist clients in executing risk management within their portfolios. Sound rebalancing involves the delicate tradeoff between risk exposure and the cost associated with doing so. It is also important to note that our team treats any cash flow event, either inflow or outflow, as an opportunity to rebalance as well. There may be times when a client’s portfolio will be rebalanced only once every couple years depending on market movement and there may be times where a client’s portfolio is rebalancing more than once a year if there is significant volatility. Although action may not be taken in a portfolio, be rest assured that our team is reviewing overall risk exposure across all of our clients’ portfolios on a quarterly basis and using a rules based process for examining the tradeoffs involved. This is just one of the many services we provide to our clients.

You can find more information about our rebalancing policy here.

IFA Painting: Balancing Act