By Dr. Jim Dahle, WCI FounderI thought it might be a good time to revisit and discuss a few things about rebalancing your investment portfolio, including the why, when, and how.
Why Rebalance Investment Accounts?
The whole point of the “know-nothing” fixed asset allocation approach to portfolio management is that you have no idea what is going to happen in the future. It is a very liberating idea because it allows you to quit spending time on activities that do not add value to your portfolio. The idea is that you focus on the things you can control—like asset allocation, costs, tax management, and receiving the “market return”—and forget everything else. Basically, you set up your asset allocation to be something like this (and I'll use my parents' portfolio as an example):
- US stocks: 30%
- International stocks: 10%
- Small value stocks: 5%
- REITs: 5%
- TIPS: 20%
- Intermediate bonds: 20%
- Short-term corporate bonds: 5%
- Cash: 5%
Over any given period of time, one of these asset classes will do better than the others, and conversely, one will do more poorly. I have no idea which, except in retrospect. However, as the percentages change, the amount of risk the portfolio is taking on changes. For example, if stocks do great for 10 years and bonds do poorly, it is quite possible that instead of a 50/50 portfolio, this portfolio becomes 75/25. A 75/25 portfolio rises much quicker when the market goes up, but it also crashes harder in a temporary or permanent downturn (the real risk of investing).
More information here:
How to Build an Investment Portfolio for Long-Term Success
The 15 Questions You Need to Answer to Build Your Investment Portfolio
Rebalancing Your Investments Gives the Investor 3 Things
#1 Risk Control
It returns the portfolio to the desired amount of risk.
#2 Rebalancing “Bonus”
It forces you to buy low and sell high, although, in general, this one is a bit of a myth. Since “high-expected return” assets like stocks actually have higher returns most of the time, selling a high-expected return asset class and buying a low-return asset class probably lowers overall returns, despite any “bonus” from buying low. However, the discipline it instills to buy something that hasn't been doing well does a lot for an investor's ability to stay the course.
#3 Something to Do
Many investors have a curious need to tinker with their portfolio. I only mess with my parents' portfolio twice a year. First, to rebalance, and second, to take out a Required Minimum Distribution (RMD). Frankly, you can do both at the same time if you like. Portfolio management can literally be that easy. It is honestly less than an hour a year. It costs them 9 basis points a year for the fund's Expense Ratios (ERs), and it provided an annualized return from mid-2006 through 2014 (through one big bear and one big bull) of 7.42% per year. My parents feel zero need to tinker, but many investors do. At least rebalancing gives them something to do rather than make a behavioral investing mistake.
When to Rebalance Your Portfolio
There are two schools of thought about rebalancing.
#1 Rebalancing Based on Time
The first is that you should rebalance based on time. Some people do it once a year—on the first of the year or on their birthday, for example—when taking RMDs or when making an annual contribution. The data shows that you probably should not do it any more frequently than once a year and that every 2-3 years is probably fine. That's not going to do much for the tinkerer, of course.
However, if you're relatively early in the accumulation stage, rebalancing once a year assumes that you're making relatively balanced contributions into your accounts. I'm not.
- I do Roth, HSA, and 529 contributions in January
- 401(k) contributions monthly throughout the first half of the year
- Top-up individual 401(k) contributions and defined benefit plan contributions around Tax Day
- Individual 401(k) and perhaps some taxable investing in the fall
Given my multi-asset class portfolio, it would be way too much of a pain (and a cost) to contribute to every asset class every time I add money to the portfolio. So, I tend to look at what's done poorly recently and rebalance with new contributions as I go along. As a young accumulating investor, it generally takes massive market movements for you to have a need to actually sell anything anyway.
#2 Event Focused
The second school of thought on rebalancing is that it should be event-focused. These folks tend to use rules like the 5/25 rule. That means if an asset class is “off” its target allocation by more than 5% absolute or 25% relative, you rebalance the entire portfolio immediately. To demonstrate how this works, let's look at a snapshot of my parents' portfolio from a decade ago.
Does the portfolio need to be rebalanced? Well, it's a little low on cash at 4%. But the difference between 5% and 4% is less than 5% absolute and less than 25% relative (meaning 1.25% absolute for a 5% asset class). The US stocks are a little high at 34%, but that's also both less than 5% absolute and 25% relative (meaning 7.5% for a 30% asset class). However, international stocks are up to 13%. While that is less than 5% absolute, it is MORE than 25% relative (2.5% for a 10% asset class). So, it is time to rebalance the portfolio.
The downsides of an event-based rebalancing plan are 1) you have to look at your portfolio more than once a year and 2) you might be rebalancing more frequently than is good for your portfolio. Sometimes, due to momentum, it actually helps to let the winners run for a little bit, which is why rebalancing no more often than once a year is probably a good idea.
More information here:
The Mechanics of Portfolio Management
How to Rebalance Your Investment Portfolio
You've determined that it is time to rebalance. How should you do it? Rebalancing doesn't make a HUGE difference, so it is very important that if you are going to do it, you minimize the costs of doing so, lest the costs outweigh the benefits. Here are some tips to reduce costs:
#1 Rebalance the Whole Enchilada
It is generally not a good idea to have the exact same asset allocation in all your accounts. Thus, you don't want to rebalance your accounts individually. Consider it all one big portfolio (at least all accounts aimed at one goal, like retirement), and manage it that way.
#2 Make a Chart
Use a spreadsheet or other chart like the one above. You can even add a column showing the dollar amounts to buy and sell with minimal Excel knowledge. It might look like this:
#3 Tax-Loss Harvest
If you have losses in a taxable account, tax-loss harvest them. Three thousand dollars worth of losses can be taken against your regular income on your taxes each year and carried forward to future years. Plus, losses can be used to offset any gains you may have from rebalancing. In fact, you should be tax-loss harvesting any time you have a significant loss, not just when it's time to rebalance.
#4 Use New Contributions
There is no cost to rebalancing with new contributions, so use them to rebalance as much as you can. If you are a beginning investor, it might be decades before you have to actually sell something to rebalance.
#5 Dividends/Capital Gains
If you avoid reinvesting your dividends and capital gains in a taxable account, those work just as well as new contributions.
#6 Beware Commissions
Depending on your strategy (mutual funds vs. ETFs), there may be a commission and a spread associated with buying and selling. Try to do your rebalancing in an account with no transaction costs. For example, a Vanguard Roth IRA invested in Vanguard mutual funds has no transaction costs, so it is a great place to rebalance.
#7 Taxes Are the Largest Transaction Costs
As a general rule, your largest transaction costs are taxes, so it is best to do your rebalancing inside 401(k)s, Roth IRAs, or other tax-protected accounts rather than a taxable account, where it may generate capital gains. The goal is to rebalance for free. My portfolio would have to be REALLY out of whack before I actually paid money to rebalance it.
#8 Don't Pursue Perfection
I've become much more laissez-faire about rebalancing in the last few years. It just doesn't matter that much. Besides, the day after you rebalance, your portfolio will just be “out of whack” again. So, don't get worked up about it. For example, your portfolio might include 10% investment real estate that is particularly hard to rebalance due to liquidity issues and transaction costs. You just can't sell 6% of your apartment building. Either deal with it or simply add a similar, but more liquid investment (like a REIT index fund) to that particular asset class. Then, you can do the rebalancing with the REIT fund. Is it perfect? No. Does it need to be? No.
Likewise, some 401(k)s (like the Federal TSP) make things tricky. You can only rebalance the account based on percentages, not dollar amounts. That's fine if it's the only investment account you own. But if you're like me, you have to convert the percentage amounts to dollar amounts before putting in the transaction orders.
Also, keep in mind that buy/sell orders have to go in at different times of the day depending on the account. If you're using ETFs, they have to occur while the market is open. With the TSP, the deadline is noon ET. With Vanguard, the deadline is 4pm ET (at market close). Although you don't need perfection, it's probably best to try to get in all your buy/sell orders on the same day when rebalancing.
#9 Take Advantage of Automation
If you're lucky enough (or unlucky enough) to only have a single investment account, feel free to use an auto-rebalancing solution such as a Vanguard Target Retirement or Life Strategy fund. This works with multiple accounts also, as long as they all have that particular investment available. Just be aware that if one of those accounts is taxable, you may be giving up a little on the tax side to improve simplicity.
Still seem too complicated? Then, hire an advisor. I list many low-cost ones here, even if the lowest-cost one can be found in your mirror each morning. If rebalancing seems too tough, actually putting the portfolio together in the first place will probably be overwhelming. The fewer the asset classes and the fewer the accounts, the easier portfolio management will be. You simply have to balance that ease of management against the possibly higher returns (and the fun you'll get tinkering) from making things more complicated.
Though my rebalancing these days is ridiculously complicated, it wasn't particularly complicated in the beginning. Just like learning to do your own taxes in residency only requires you to learn one or two new things every year, adding another asset class or account every now and then isn't that big a deal. Excel is your friend.
What do you think? Why do you rebalance your portfolio? When do you do it? How do you do it?
[This updated post was originally published in 2015.]
Great reminder for investors to keep on top their asset allocation. It can be a shock to many how quickly risk can drift if left un-attended. I once saw a portfolio that hadn’t been rebalanced in 10 years, and everything has essentially shifted to a single fund.
“It is generally not a good idea to have the exact same asset allocation in all your accounts.”
Can you explain the reason behind this? Is it just the tax efficiency of some assets compared to others and their placement in tax advantaged vs taxable accounts?
Yes, just that.
Hey Jim,
On that specific topic of asset location in various accounts, I’m wondering what your view is on how rebalancing over time might adversely affect a retirement distribution strategy. Rebalancing tax-efficiently over the years should mean one’s taxable account eventually gets loaded up with equities. That leaves it more vulnerable to market volatility, bear market drawdowns, etc. Yet conventional advice suggests tapping taxable accounts first for retirement distributions, because capital gains taxes are usually lower than those triggered by 401k account withdrawals. In a market drawdown, is it better then to pull from tax-deferred accounts? Switch back and forth based on what the equity markets are doing?
Asset allocation decisions are separate from asset location decisions.
If you’ve chosen to withdraw from taxable, and you own stocks in taxable and stocks are down, great! You sell the stocks in taxable, pay less in capital gains, and swap some bonds in tax-protected for stocks to rebalance the portfolio to the asset allocation you want.
If you’ve chosen to withdraw from taxable and you own stocks in taxable and stocks are up, great! You now have more money. You sell the stocks in taxable, pay more in capital gains, and that sale helps to rebalance the portfolio.
So I’m not sure why you wouldn’t just do that.
Do your parents take their RMD’s all at once, or do they spread them out? If all at once, how did they decide when they would take it? How do they decide which account to take it from.
I took my first RMD and just ended up taking it all at once just so I wouldn’t have to think about it. I don’t need the money ($66,000) so I wanted to reinvest it in Fidelity total market fund, so I had to open a new fund in my brokerage account. Fidelity can’t set up monthly transfer from my IRA if it’s going into this fund because I’m not selling the fund from my IRA. I’m doing a direct transfer. If I sold the funds in IRA and then rebuy the total stock market, then they could set up automatic monthly RMD withdrawal. Hope this makes sense! I was so overwhelmed trying to figure this out!
You must imagine a lot more complication in life than most people have. There is only one account each to take RMDs from and since they don’t spend them, the RMD is mostly moved to taxable in December to maximize tax protected growth time. Of course it’s all done at one time. Who’s got time to do anything else? Sell to taxable MMF. Buy desired fund in taxable. Withhold most of the year’s tax bill and make any QCDs at the same time.
What tool or website do you recommend for visualizing overall allocation across accounts (401k, Roth, taxable) and companies (Vanguard, Fidelity) and funds (I.e. target date funds).
Well, you can certainly do that manually using Excel. But it sounds like you want something a bit more automatic. The old Morningstar Instant X-ray tool did what you’re looking for once you added in your holdings manually, but it’s now behind a paywall. Maybe try that.
Given the whole capital gains distribution debacle a few years back ( https://www.whitecoatinvestor.com/vanguard-target-retirement-distribution-disaster/comment-page-2/ ) this paragraph might warrant a bit of a stronger warning for using target retirement funds in taxable accounts:
“feel free to use an auto-rebalancing solution such as a Vanguard Target Retirement or Life Strategy fund. This works with multiple accounts also, as long as they all have that particular investment available. Just be aware that if one of those accounts is taxable, you may be giving up a little on the tax side to improve simplicity.”
I’m in a bit of a conundrum. I’m retired and in my 70’s. My current asset allocation/location is 50% in taxable account (all stock with 50% cost basis), 35% in Trad IRA (all bonds), and 15% in ROTH (cash). My ROTH was originally all stock, but that made me too heavy in stock so I converted it all to cash since I did not want to pay capital gains by selling stock in my taxable account. My long term strategy is to leave the bulk of the taxable account to my estate in order to get the step-up in basis and just live off of RMD’s , dividends, and social security. Would I have been better off keeping the ROTH in stock and selling stock in my taxable account (and get hit with capital gains) in order to rebalance?
So your desired asset allocation is 50% stock? I’m not sure you’re going to be able to avoid selling in taxable if you’re doing this right. It seems foolish to drain a Roth in order to give more taxable to heirs since the Roth will grow without taxation another 10-20 years for you and 10 years for them. Are you spending as much as you wish to spend or does the strategy of spending only income and RMDs and SS really provide as much as you want to spend?
Yes, my target is 50% stock. The combination of income, RMD, and SS is sufficient for our needs. We have no mortgage and are very content living a fulfilling, but modest, lifestyle. I’d really like to see my ROTH grow, hence my concern about having it all currently in cash.
Since you (probably) won’t be spending your Roth money, why not take it out of your asset allocation since it has a different goal than the rest of the money and then invest it aggressively. Make the rest of the portfolio 50/50 and the Roth 100% stock.
That’s an interesting idea. I’ve always viewed my assets as a single group to be managed under a specific allocation plan. I have to get my head around the idea of viewing the Roth as a separate entity with its own goals and allocation. Thanks for your comments and insights. They are very helpful.
I think reposting high-value blogs like this one is great. I had never read this one and it has a lot of wisdom.
One of the best things about rebalancing that I did not realize (until I started doing it) was that if the stock portion goes up, you are out of balance and you should sell, in general at a gain (depending on what you sell).
This reinforces the buy-low-sell-high idea. I know Jim says it is kind of a myth since you give up possible unrealized gains. But what I did was look at my basis for a few appreciated funds, take inflation into account, and sell that amount until I got back to my allocation goal. My reasoning was any money I had leftover was locked in profit, since I got back my original basis cost.
In a way it also forces you to buy-the-dip, since low stock value will raise the low-risk allocation portion and I then wind up putting those funds into an index.
Maybe my process is kind of naive, but I cannot complain about where I have wound up. And I sleep fine at night…
Love this repost!
Frankly, pretty good time for it too given the recent craziness in the stock market. The recent runup in large cap, then volatility, then the unexpected huge gains in international has been really caused my portfolio to be super skewed.