Rebalancing Portfolios

Rebalancing Portfolios

Rebalancing Portfolios
Balancing Act
Balancing Act

It is important for investors to rebalance their portfolio to achieve risk control and maintain long-term investing goals. An investor's portfolio should match their Risk Capacity™ which is best measured through a Risk Capacity Survey.  As Risk Capacity™ changes with age and new life circumstances (not with market conditions), it is prudent for investors to check their risk capacity using a survey at least annually. Investors then need to take the next step to rebalance their portfolio’s asset allocation or risk exposure and to ensure that the portfolio continues to reflect the level of risk an investor has the capacity to hold.

For example, after a thorough evaluation of risk capacity, an investor may be matched to an index portfolio of 65% equities, 35% fixed income. After a year of increased equity prices, the equity portion of the portfolio rises to 75%, with fixed income at 25%. By contrast, after a market decline you may discover that your allocation is now 60% equities and 40% fixed income. These shifts in asset allocation are to be expected, as index values change at different rates. Rebalancing back to the initial or target allocation keeps the portfolio at a consistent risk exposure and therefore, at a somewhat consistent expected return. In either example, a certain set of rebalancing trades would correct the asset allocation back to 65% equities and 35% fixed income.

Rebalancing on average involves selling equities after gains and buying equities after losses. Many investors make the costly mistake of doing the opposite, buying after gains and selling after losses, resulting in a misalignment of risk capacity and risk exposure. Selling indexes that have performed well and buying more of the indexes that have performed poorly is often an emotionally difficult task for investors, as it seems counterintuitive and confusing. The counterintuitive logic of rebalancing often leads investors to either do nothing, or even worse, to follow their fight or flight instincts and sell the losers and buy more of the winners, going completely against the prudent principle of rebalancing. A portfolio that is neglected or not rebalanced appropriately takes on a less than optimal risk-return trade-off. More to the point, the investor no longer has the confidence of knowing the expected return or the potential risks of their neglected portfolio, which are keys to prudent investing.

According to Michael Rosenbald at, an AllianceBernstein survey of 1,000 investors showed that nearly 40% of investors without an adviser did not have an approach for allocating and rebalancing investments. Some 55% of those people reported that they never got around to doing it. Most startling: 70% of investors, including those with an adviser, said they are prone to change their hairstyle more frequently than they rebalance their portfolio.

There are certain obvious times when it is wise to consider changing index portfolios because of a change occurs in the investor’s capacity for risk. These times include:

  1.    when investment goals change
  2.    when income level significantly changes
  3.    when investable wealth significantly changes
  4.    when the time horizon for spending your portfolio changes (e.g. retirement)
  5.    when life conditions change - medical, emergencies, marriage, divorce, etc.

Rebalancing Formula

The logic behind rebalancing is that it maintains a consistent level of risk exposure. There are several rebalancing formulas that are used in the investment industry. Although rebalancing is necessary to maintain risk, it can incur transaction fees and taxes. For this reason, rebalancing is a decision that should be handled with care. No formula can be right in every situation nor should a formula be used absent thoughtful and professional reflection. Nevertheless, a good rule of thumb is to set a target percentage for each asset class and then create a percentage high and low threshold around the each target. The percentage weights of each asset class in the portfolio should be evaluated quarterly vis-à-vis the thresholds, which will alert the investor to consider a rebalance. In addition, investors should assess their risk capacity once a year or upon any significant change in their lives and adjust the target asset class weights accordingly.

What is an appropriate rule to set the high and low threshold around a target asset-class weight? One common approach is the absolute 5 percent variance (as a percentage of the portfolio) trigger. This rule states that it may be time to rebalance when a general asset class moves an absolute 5% from its original allocation percentage. For a volatile asset class that makes up a relatively small percentage of the portfolio, a relative 50% variance (as a percentage of the target allocation) would trigger a rebalance review. IFA uses a combination of the absolute 5% variance (as a percentage of the portfolio) and the relative 50% variance (as a percentage of the target allocation) depending on the asset class and target percentage within the portfolio.

IFA's rebalancing policy can be simply explained as follows: IFA has a risk scale from 1 to 100. When IFA assesses that a client's portfolio has moved 5 or more risk levels away from the targeted risk level, then IFA will normally recommend a rebalance. By far, the most common reason for the portfolio to have moved 5 or more risk levels from the target is due to a change in the breakdown between equities and fixed income by 5 or more percentage points. In order to reduce small and costly trades, IFA also requires a general asset class to be at least $3,000 from its target dollar allocation before IFA considers the general asset class out of balance. Also in order to reduce excess trades, IFA will delay rebalancing where it has knowledge of upcoming withdrawals or deposits. Where possible, IFA will also avoid realizing short-term gains by waiting for them to become long-term.

Rebalancing among several taxable and tax-deferred accounts is a very complicated process, but necessary so that all assets can be considered. Highly sophisticated software is required with many factors to be considered, such as the need for liquidity versus the need for reduced volatility. There are significant tax implications for placing index investments in Roth, traditional tax-deferred, and taxable accounts and determining which to buy and sell during a rebalance. Whenever possible you should rebalance using deposits to or withdrawals from the portfolio as it reduces trades and potentially taxable gains as well.

While IFA's rules are useful to indicate that a portfolio should be reviewed for rebalance purposes, it should not be used without consideration to other factors. Placing rebalance trades in a portfolio ultimately depends on the objective of risk control; aligning the risk exposure of the portfolio with the risk capacity of the investor. Specifically, since risk is the source of returns, the trades should result in either:

  1. An increase in the portfolio’s risk level back to the target allocation (which normally occurs when we sell fixed income and buy equities).
  2. A decrease in the portfolio’s risk level back to the target allocation (which normally occurs when we sell equities and buy fixed income).

In general, selling one class of equities to purchase a different class of equities does not result in a significant change in the portfolio's risk level, as measured by the long-term historical standard deviation of returns. Put in other terms, selling a small percentage of the portfolio’s International Equity to buy a small percentage of US Equity does not typically alter the portfolios overall risk/return characteristics, but will incur trading costs and may realize capital gains.

In summary, rebalance trades should be done in order to realign the risk exposure of the portfolio with the risk capacity of the investor, but the potential benefits of the trades must be considered against the tax consequence and trading costs.