Portfolio Rebalancing: Which Method Is Best for Retirement?

 

Portfolio rebalancing is simply the process of realigning your investments back into their original proportions. Just like your car tires, if you don’t rebalance occasionally, things can get out of whack. Today, we’re going to discuss the different methods of portfolio rebalancing and why it’s important for your retirement.

Why Rebalance?

If you’re saving for retirement (or have recently retired), you no doubt have a target asset allocation for your investments that will support your long-term growth and cash-flow needs. However, when stocks grow, the proportion of these riskier assets increases over time, making you more susceptible to a market downturn.

Correspondingly, if stocks go down, your overall risk (and expected return) will be lower than your target, meaning that you’ll potentially miss out when stocks eventually rally. In both scenarios, a portfolio rebalancing process allows you to methodically buy low and sell high over time.

Another reason to rebalance is the opportunity for higher long-term returns. Some studies demonstrate that, when implemented, a portfolio rebalancing process can add almost 0.5% in additional annual returns over time. That may not sound like much, but when compounded over the years, it can become a significant sum.

Of course, if you’re using a target-date retirement fund, you don’t need to rebalance – it’s all done for you. Rebalancing comes into play when you have multiple stocks, ETFs, or mutual funds in your accounts.

Time-Based Portfolio Rebalancing

There are two methods of portfolio rebalancing: time-based and rules-based. In a time-based portfolio rebalancing process, you simply review your investments at set intervals to determine if you need to make any trades. These intervals can range from once a month to once a year.

What interval is best? Well, rebalancing daily is certainly too frequent. If you were review and rebalance your investments every day, there’s a good chance you’ll trade too often, especially in times of market volatility. In other words, you may have to make trades one day that “un-do” the ones you made the day before. That brings a lot of potential trading costs (and stress) into the equation.

For most do-it-yourselfers, rebalancing annually works just fine. Some studies suggest that there’s a negligible difference in returns between rebalancing monthly, quarterly, or annually, so why not choose the simple route?

In an annual rebalancing process, you would sell off any funds that were greater than their target percentage (sell high) and buy more of the funds that were below their target (buy low). Lather, rinse, and repeat every year.

Rules-Based Portfolio Rebalancing

Moving up a level in complication, a rules-based rebalancing process kicks in after a portfolio component drifts outside of its rebalancing “band”. The most frequently used rule to establish a rebalancing band is by a fixed percentage, commonly 20%.

For example, if you’ve allocated 20% of your portfolio to international developed stocks, they would be allowed to drift by 4% in either direction. If 20% of 20% is 4%, then the rebalancing band for this asset class ranges from 16% to 24%. Once your international developed stocks drift outside this window, it’s time to rebalance.

You’ll notice that a 20% variance is quite a lot. Why not use a tighter window? Well, if you tighten the bands too much, you run into the same issue with daily time-based rebalancing: trades one day can un-do the ones from the day before.

Wide rebalancing bands may be appropriate in volatile times to prevent over-trading, but what happens when the markets are calm? If you really wanted to get fancy, you could base your rebalancing band rules around a proxy for market volatility, such as the CBOE’s Volatility Index (a.k.a. the VIX), instead of a fixed number.

Portfolio Rebalancing Costs

There can be costs associated with making rebalancing trades. Commonly, your brokerage firm will charge a transaction fee for any trades you make. Fortunately, these fees have been massively compressed over the years – and now there are plenty of “no transaction fee” options at most of the major brokerage firms.

While transaction fees have come down, taxes have not. If you make trades in a taxable brokerage account, you’ll be liable for any short- or long-term capital gains taxes caused by those trades. This is another factor to consider when choosing a portfolio rebalancing method. If you rebalance too frequently, you may see a higher tax bill.

Finally, in times when stocks are rising, you may notice that you underperform the stock market in general. This makes sense – you’re not taking the same risk as you would be were you 100% invested in the stock market. Logically, you wouldn’t expect the same returns over long periods of time. Measuring a traditional 60/40 retirement portfolio against the S&P 500 isn’t a fair comparison.

Portfolio Rebalancing Mechanics

If you’re simply rebalancing your 401(k) account, the process can be quite easy. There are often two sections when it comes to investment choices in a 401(k) plan: existing investments and future contributions. To rebalance, simply adjust the proportions of your existing investments back to your original allocation. These days, some plans even offer an auto-rebalancing option.

If you have multiple accounts at a brokerage firm, things can be more complicated. In these cases, asset location becomes a factor. Tax inefficient investments like bonds and REITs can add to your yearly tax bill if they’re located in an after-tax brokerage account. Housing them in an IRA makes more sense. However, you may also want to use a portion of your IRA to house some stock investments so you can rebalance without worrying about capital gains.

Which Portfolio Rebalancing Method is Best?

In the end, there’s no one portfolio rebalancing method that’s better than another. The rules-based process is more methodical, but also more complicated. If you don’t like the idea of looking at your investments every day – then time-based rebalancing may be for you.

For savers and retirees who want to invest on their own, annual rebalancing is as good a process as any. Block off half an hour on your calendar every year to review and rebalance. The best portfolio rebalancing process is the one that you’ll actually use.

If portfolio rebalancing sounds too complicated and you’d prefer to have a professional do this for you, then click here to set up a quick, complimentary introduction call to see if Prana Wealth is a good fit. We do still have the capacity to take on new clients.

As a fee-only financial advisor in Atlanta, we can (and do) work virtually with clients all across the U.S. and we’re here to help you when you’re ready.


The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but is intended to help manage risk and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax, or financial advice. Please consult a legal, tax, or financial professional for information specific to your individual situation.
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