[Update 2020: Over the last year or two we've been updating a lot of our classic posts that regular readers have never seen. Jill, our content manager, is in charge of selecting them (along with guest posts and the Saturday WCI Network posts). When she saw this one she said, “It's cool to see your investing strategy hasn't changed since 2011.” Little did she know, it hasn't changed since 2004. I guess it's kind of boring to buy, hold, and rebalance a fixed asset allocation of low-cost, broadly diversified index funds. But it is effective. Fund it adequately and it'll get you to your goals with a minimum of risk and very little effort. Today, we'll hit that third part–rebalancing. Be sure to include a line about rebalancing in your written investing plan. No written investing plan? You're not alone (see the poll below), but you'll do better if you get one.]
My long-time readers (as if there are any on a 3-month-old blog) know that I am an advocate for a low-cost, buy-and-hold, static-asset-allocation portfolio. A key component of a “static asset allocation” is that in order to keep it “static” you must occasionally rebalance back to the desired allocation. A portfolio that is 50% stocks and 50% bonds has a different expected return and level of risk than a 75/25 portfolio.
Two Major Schools of Thought on Rebalancing
Rebalancing on a Set Time Interval
The first is that you rebalance on a set time interval. Some portfolios, most famously Yale's Endowment Portfolio, are rebalanced on a daily basis. However, studies seem to indicate that you don't want to rebalance much more often than once a year, and that every 2 or 3 years is probably fine due to momentum in the market.
So, to keep things simple, many investors simply rebalance on an arbitrary date each year, perhaps December 31st, perhaps their birthday, perhaps tax day.
I help my parents with their portfolio, and they rebalance each March. I'm amazed at how well that has worked out for them the last few years. They ended up rebalancing into stocks at the perfect time in 2009. At a time when many others were fearful to put money into the stock market, they did so simply because that was the investment plan, no emotion involved. They also avoided “catching a falling knife” (like I did using the 5/25 rule) as the market went down, down, down in the Fall of 2008.
5/25 Rule Rebalancing
The second school of thought is to follow the 5/25 rule. This rule has you rebalance using bands. The downside to this is you actually have to pay some attention to the market occasionally to know if you've gone outside your bands. The upside is that it ensures your asset allocation stays within bounds that you set.
What Does the “5” Mean?
The “5” portion of the rule means that if an asset allocation deviates by an absolute percentage of 5% of the portfolio then you rebalance it. This refers to the big blocks in your portfolio. For example, if your portfolio calls for 30% international stocks you'll rebalance when that percentage hits either 35% (selling some) or 25% (buying some more.)
It may also refer to the overall stock:bond ratio. For example, a 50% stock portfolio may need to be rebalanced if it becomes a 45% stock portfolio, even if none of the individual stock asset classes have fallen enough to justify a rebalancing event. For example, a portfolio that is 25% US stocks and 25% international stocks where both components have fallen to 22.5% of the portfolio.
5/25 Rebalancing Rule Example – What Does the “25” Mean?
The “25” portion of the rule refers to the smaller asset classes in the portfolio, for example, those chunks that may make up only 5-10% of the portfolio. This refers to a change in the asset class that is a relative 25% of that asset class. If your asset allocation calls for a 10% allocation to gold, for instance, then you would rebalance when it hit 12.5% (sell) or 7.5% (buy). Likewise, a 5% position to emerging market stocks would be rebalanced at 3.75% and 6.25%.
Rebalancing Using New Money
Many young accumulating investors (read, small portfolio relative to annual contributions) are usually able to rebalance using new money. I simply direct my contributions to the asset class that is lagging. It takes a major market movement for me to need to sell anything even using the 5/25 rule.
Rebalancing to Minimize Taxes
It is also wise to avoid accumulating unwanted taxes by rebalancing. If you're careful, you can rebalance while eliminating or at least minimizing taxes by following these steps:
- Direct new contributions to lagging asset classes.
- Don't reinvest dividends/capital gains distributions in a taxable account. Direct these to lagging asset classes.
- In a taxable account, sell investments with a capital loss. This doesn't happen often, as you usually need to buy more of the classes that have recently performed poorly, but through careful tax-loss harvesting, you can often sell some losing investments to cancel out some or all of the capital gains you may generate through rebalancing.
- Try to do all or most of the necessary selling in a tax-protected account. Although commissions or fees may be generated (hopefully not), there are no taxes due from buying and selling in a Roth IRA, 401K, or similar accounts.
When selling investments in a taxable account, consider less frequent rebalancing intervals, perhaps even every two years. Also, only sell investments with a long-term capital gain (one year) rather than a short-term capital gain.
Be careful not to let the tax tail wag the investing dog, but keeping expenses, including taxes, down is an important part of investing. Investing, more than anything else is about managing risk. Rebalancing is an important risk management tool. When markets trend down like they have recently, you should always consider if it is time to rebalance (as well as tax-loss harvest.)
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I personally have been directing new money (I contribute regularly 2x/month) to any asset class that is lagging. I was wondering if I lose any of the benefits of traditional rebalancing by doing it this way (traditional rebalance forces you to sell an asset class that is doing well (sell high) and buy an asset class that has fallen (buy low) which is the basic driving force of what you want to do in investing).
If I am just putting new money into the lagging classes (buying low) do you see any detriment for missing on the 2nd part (selling high)?
No. That’s fine. In fact, that’s how most do it most of the time throughout the first half of their investing careers.
Given the recent extreme volatility in the market, what are your thoughts about lowering the bands and increasing the rebalancing frequency?
For example, instead of 5/25, you change it to 5%/10%.
Assuming we can ignore taxes and trading costs, what are the implications?
Interested in hearing your thoughts.
You can put whatever rule you like in your written investing plan. I then recommend you follow it. The implications are more frequent rebalancing for better or worse.
That’s the real question: Does more frequent rebalancing help returns during periods of extreme volatility?
Wonder if there any been any studies on this?
The studies show that on average rebalancing once every 2-3 years seems to be best.
Can you explain the advice not to reinvest dividends in taxable accounts? I’ve seen that in a couple posts and I don’t completely understand the downside. When tax loss harvesting if a recent dividend has been paid does that make the whole sale a wash sale or just the small proportion that was from the recent (within 30 days) dividend reinvestment? Any other reason not to let the dividends reinvest if Vanguard is keeping track of the basis anyway? Thanks
The small portion. Keeping track of small lots is the only other downside.
Thanks for the reminder to use the 401k to balance and not the tax account. Hard to keep track of all these rules and considerations.
I think with index target retirement funds being so cheap, that is the best option. No work on your part for rebalancing…
I check for rebalancing twice a year, late June and late December.
I actually sell shares to rebalance rarely. Less than every 2-3 years.
In between I shift my autopilot investments toward the asset that is lower than target.
I use wide bands because my target allocation is nothing more than a lightly educated wild guess as to what I would consider optimal. No way to argue that 65% is better or worse than 60% stocks, for example. So if my 60 goes to 67% due to market movement, I don’t care. I do force myself to do something if the allocation gets more than 10% outside its target. This is usually just a shift in new money investment.
When I actually sell, I go all the way back to the target allocation. In this example, I would go from 70% back to 60%, then follow the same indolent practice until allocation was outside my bands in late June or late December.
With wide bans, twice a year checking and shifting of new money, sales to rebalance come up rarely.
All such sales to rebalance are in tax advantaged accounts.
Sounds like you’re doing it exactly right to me.
Thank you explaining the conecpt of rebalancing. My question may seems silly ,but I am rookie to this wode world of investment. Ususally we have all the accounts in different places,-like vangaurd, td ameritrade and fidelity and 401 K from employer. How do you keep trak of your stock /bond ratio. Lets say its 60/40. Do I need to make it 60/40 in each account? That seems to much complicated. But if I am targeting overall investment 60/40, doen’t matter what ratio my individul acclunt has, then do i need to make excel sheet and put number from each account to check and keep track of the overall ratio for rebalancing?
That’s exactly what I do. I keep track on a spreadsheet. Look at all accounts aimed at one goal as a single big portfolio.
This page gave me the basis to write my IPS and do a deep dive into our investments so first off thank you very much. There is one bullet point I don’t understand on tax minimization though:
-Don’t reinvest dividends/capital gains distributions in a taxable account. Direct these to lagging asset classes.
Can you help me understand how this reduces taxes? Ours is currently set to auto reinvest.
Thank you very much!
It prevents later sales with the payment of capital gains taxes in order to rebalance. Plus it makes for fewer tax lots to keep track of when tax loss harvesting.
Written plan was to rebalance yearly. I have not followed through and it has been two years. Question is do I just do it now or do I hold off until the market improves? I understand the market should not impact this decision, but just double checking how you would go about it. I do plan to revert back to the yearly rebalancing. Thanks!
Are you going to be able to follow your plan now? Did you just forget? Did you refuse to rebalance because you had FOMO? Do you need an advisor? All questions running through my head.
But I rebalance when I see a need to rebalance. I don’t know if you have that now or not since both stocks and bonds are down, although stocks > bonds. If your plan is yearly and you forgot, then I’d do it ASAP and then do it again next July.