Rebalancing Portfolios

Rebalancing Portfolios

Rebalancing Portfolios
Balancing Act
Balancing Act

It is important for investors to rebalance their portfolios to achieve risk control and maintain an individual's long-term investment goals. This process should match someone's level of risk capacity, which is best measured through a Risk Capacity Survey

As investment appetites for risk change with age and new life circumstances (not market conditions), it is prudent for investors to check their Risk Capacity Survey at least annually.

Investors then need to take the next step to rebalance their portfolio's asset allocation, or risk exposure, to ensure that these investments continue on the whole 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 and 35% fixed income. After a year of increased equity prices, say the equity portion of that portfolio could rise to 75%, which would leave fixed income at 25% of total portfolio assets. By contrast, after a market decline you may discover that equities now comprise 60% of the portfolio's overall allocation and fixed income has increased to 40%.

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 of the above examples, 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 exact 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 conversely 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 while buying more of the winners.

This goes 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.

Keeping an appropriate risk-return profile for a portfolio is important in order to reduce any natural inclination by investors to move in and out of markets as conditions change over the short-term. In their long-running research series looking at triggers for poor investment behavior, analysts at Dalbar Inc. point to these upheavals as a constant pull over time. Such an ongoing tug of emotions leads to the average U.S. investor's fund portfolio to sometimes dramatically underperform against a buy and hold index-minded strategy. 

As part of its Advisor's Alpha research series, Vanguard seeks to quantify how much value rebalancing might mean to investors. In their report ("Putting a Value on Value: Quantifying Advisor's Alpha," February 2019, page 13), the fund company's analysts crunched data from 1960-2017.

They found a more heavily tilted stock index portfolio (80% stocks/20% bonds) that was annually rebalanced gained more in terms of average annual returns than a less aggressive index portfolio (60% stocks/40% bonds) that was left to drift (i.e., not annually rebalanced) over this period: 9.71% vs. 9.45%. Conversely, an annually rebalanced 60/40 index portfolio produced an average annual return of 9.05%. 

Just as significantly, the index portfolio with a more aggressive tilt to risk assets (80% stocks/20% bonds) and annually rebalanced generated average annual standard deviation (a common measure of risk) of 13.78%. By contrast, a more conservative (60% stocks, 40% bonds) index portfolio that wasn't annually rebalanced produced an annual standard deviation of 13.76%. Meanwhile, a 60/40 index portfolio that was regularly rebalanced had a significantlly lower level of risk -- an average annual standard deviation of 11.09%.  

The goal of rebalancing, Vanguard's analysis summarizes, is about controlling risks. "Helping investors stay committed to their asset allocation strategy and remain invested increases the probability of their meeting their goals," the paper concludes. 

There are certain obvious times when it is wise to consider tweaking index portfolios because of a change 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 each target. The percentage weights of each asset class in the portfolio should be evaluated quarterly vis-a-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 target asset class weights accordingly.

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 five or more risk levels away from the targeted risk level, then IFA will normally recommend a rebalance.

By far, the most common reason for a portfolio to have moved five or more risk levels from the target is due to a change in the breakdown between equities and fixed income, typically by five 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 considering the general asset class as '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 a Roth account, traditional tax-deferred account 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 rebalancing purposes, it should not be used without consideration of other factors. Placing rebalancing 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 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.

This is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product or service. There is no guarantee investment strategies will be successful.  Investing involves risks, including possible loss of principal. IFA utilizes standard deviation as a quantification of risk, see an explanation in the IFA glossary. IFA Index Portfolios are recommended based on time horizon and risk tolerance. Take the IFA Risk Capacity Survey to determine which portfolio captures the right mix of stock and bond funds best suited to you.  For more information about Index Funds Advisors, Inc, please review our brochure at