Portfolio Rebalancing- The Hows and the Whys

Timothy GroveMarch 2, 2017


Because portfolio rebalancing affects all HFA clients, it merits an in-depth discussion.  As our clients know, we do not believe in “market timing” or in making investment decisions based on short-term market fluctuations.  Rather, we believe in an approach that is consistent with each client’s long-term goals and risk tolerance, and we maintain that approach unless and until circumstances change.  This approach manifests itself in an asset allocation or an investment policy that seeks to provide the best tradeoff between short-term volatility and long-term return potential for the individual client. 

Generally speaking, a client’s risk tolerance determines the allocation to the major asset classes:  stocks (a.k.a. equities) and bonds/cash.  However, within these major asset classes are sub-asset classes, each of which has its own target allocation as a percentage of the major asset class to which it belongs.  These allocations are the same regardless of the allocation to the major asset classes.  For example, at HFA we give U.S. small cap stocks a target of 10% of the equity allocation.  This is true despite the allocation to the major asset classes.  So for a 60/40 stock/bond portfolio (moderate growth strategy), U.S. small caps would be 10% of 60%, or 6% of the overall allocation, while for a 30/70 stock/bond portfolio (conservative strategy), U.S. small caps would be 10% of 30%, or 3% of the overall allocation.  We assign target allocations to other sub-asset classes as well; again, these are a percentage of the major asset class to which that particular sub-asset belongs.  We also believe in maintaining a balanced allocation to “value” and “growth” style stock funds.

Since it is impossible to know which of the major asset classes, or which of the sub-asset classes within them, or “value” or “growth” style stocks, are going to outperform at any given time, the prudent approach is to maintain a balanced and diversified allocation.  Of course, the reason for having a diversified portfolio is because   various types of holdings perform differently from one another and therefore potentially reduce volatility.  However, a side effect of this performance over time results in a portfolio’s allocations drifting from their targets unless regular rebalancing back to the targets is executed.  This requires that holdings, which have outperformed are trimmed and the proceeds are invested in the underperforming holdings.

At first glance, this process runs contrary to human nature itself. We tend to want to invest more in the winners and less (or nothing) in the losers, right?  But regular rebalancing to targets employs a proven long-term investment discipline:  selling high and buying low.

Rebalancing also keeps the portfolio aligned with the client’s risk tolerance.  On this subject, it is important to remember that there are two kinds of risk.  The first (and more well-known) type is investing too aggressively and having too much volatility.  This will result if a portfolio is not rebalanced after stocks have done well.  The second (and less well-known) type of risk is investing too conservatively and not maintaining purchasing power, a topic I addressed in a previous blog article.  This would result from a portfolio not being rebalanced after bonds had outperformed stocks.

Interestingly, rebalancing can also provide increased returns over a portfolio that is not rebalanced; this phenomenon is known as the “rebalancing bonus” and is illustrated in the studies referenced in the links below.  Perhaps most striking is this illustration: Rebalancing increases a portfolio’s return even though one of the asset’s annual returns is negative.  In this case, the rebalancing bonus is largely a function of the asset’s volatility and makes the case for rebalancing between the sub-asset classes within the larger stock allocation.

Thus, in addition to rebalancing between the major asset classes of stocks and bonds, rebalancing can (and should) also be done among the sub-asset classes such as  among large, mid, and small cap stocks, growth and value style stocks, U.S. and international stocks, and developed markets and emerging markets.  In the fixed income space, rebalancing can also be done between U.S. and international bonds.  All of these components of a diversified portfolio will behave and perform differently relative to each other over time and will need to be rebalanced.

HFA generally rebalances when the allocations to the major asset classes (stocks and bonds) deviate more than plus or minus 5% from their targets.  However, rebalancing (both among the major asset classes and sub-asset classes) will also be done in conjunction with other necessary tasks, such as raising cash or investing new assets, integrating an outside portfolio, or making a fund swap.  But as important as rebalancing is, we are always sensitive to trading costs and tax consequences.  Where possible, we will consolidate trades and perform rebalancing in retirement accounts in order to mitigate these effects. If you wish to discuss rebalancing, please call us. Thank you for your valued business.


The Case for High Volatility Strategies

Rebalance Your Portfolio to Stay on Track

Efficient Frontier – The Rebalancing Bonus

The Personal Finance Engineer – The Mythical Rebalancing Bonus Part 1

The Personal Finance Engineer – The Mythical Rebalancing Bonus Part 2

Morgan Stanley – The Rebalacing Effect

The Science of the Rebalancing Bonus

The Rebalance Bonus for Value and Momentum Portfolios