Rebalancing Portfolios

Tuesday, August 20, 2019 19,958 views
Balancing Act
Balancing Act

It is important for investors to rebalance their portfolios periodically to achieve risk maintenance. This process adjusts the portfolio's risk exposure to match the investor's risk capacity, which is best measured through a Risk Capacity Survey

For example, after a thorough evaluation of risk capacity, an investor purchases a globally diversified index portfolio of 65% equities and 35% fixed income. After a year of increased stock market performance, the equity portion of that portfolio could rise to 75%, which would leave the fixed income portion 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 over the life of a portfolio. Rebalancing back to the initial or target allocation keeps the portfolio at a relatively consistent risk exposure and, therefore, at a somewhat consistent expected return. In either of the above examples, a set of rebalancing trades would correct the asset allocation back to 65% equities and 35% fixed income. 

Rebalancing involves selling assets that have gone up and using those proceeds to buy assets that have gone down. 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 past losers to buy more of the previous 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 asset allocation 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 underperform against a buy, hold and rebalance strategy. 

As part of its Advisor's Alpha research series, Vanguard seeks to analyze the value of rebalancing for 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 that a 60% stock/40% bond portfolio that was rebalanced annually provided a marginally lower average annual return (9.05% versus 9.45%) with a significantly lower average annual standard deviation (a common measure of risk) of 11.09% versus an average annual standard deviation of 13.76% for a 60% stock/40% bond portfolio that was not rebalanced. As a result, the portfolio that was allowed to drift and not rebalanced did not earn a risk appropriate return. 

In addition, their study revealed that a portfolio with 80% stocks/20% bonds that was rebalanced annually produced a greater average annual return (9.71% versus 9.45%) with a comparable standard deviation (13.78% versus 13.76%) than a 60% stocks/40% bonds portfolio that was not rebalanced. This is further evidence that supports IFA's view that the goal of portfolio rebalancing is to control risk and not maximize returns. Maintaining a consistent risk exposure over time helps investors to stay committed to their asset allocation and increases their probability of meeting their investment goals.   

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 in taxable accounts. 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 approximately 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 utilizes highly sophisticated software to review all client accounts for potential rebalancing during the first week of February, May, August and November each year. Client portfolios are evaluated based on predetermined tolerance bands, trading costs and potential tax consequences. Once an opportunity is identified, an email containing the details of the recommended rebalancing is sent to each client that has not opted for auto-rebalance. Upon receipt of approval from the client, IFA will process the rebalancing trades. For clients that have opted to sign-up for automatic rebalancing, the trades will be completed after the review.  This process can take approximately 30 days to complete for all clients. 

In summary, rebalancing is designed to keep an investor's risk exposure consistent over time and in-line with their capacity to hold risk.

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 Fund Advisors, Inc, please review our brochure at

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