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Rebalancing act
What are your guidelines for rebalancing a portfolio?
November 7, 2003: 11:14 AM EST
By Walter Updegrave, Money Magazine

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NEW YORK (CNN/Money) - Are there any guidelines for rebalancing your portfolio? I have been rebalancing yearly, but would I be better off doing it quarterly or some other way?

-- William Coyne, Highland Park, Illinois

Even though rebalancing is one of the most important and valuable things an investor can do -- indeed, I'd say the most important, next to setting an asset allocation strategy -- I suspect that most investors don't do it, or at least not regularly.

So you're to be congratulated for doing any type of rebalancing at all. But before I get into the pros and cons of different rebalancing strategies, let me first try to convince those investors out there who don't rebalance in any way shape or form why it's important that they do so.

As I've already said, setting your asset allocation, or the mix of stocks, bonds and cash in your portfolio, is your single most important task as an investor. That's because the proportion in which you hold stocks vs. bonds (as well as different types of stocks and bonds) generally has a greater effect on your portfolio's returns and its volatility than the individual investments you choose.

Which is why I recommend that the first thing any serious investor do is create an asset allocation, or mix of assets, that's appropriate for his or her investment goals. For help in doing that, click here.

Balance and re-balance your mix

Okay, let's say that you determine that a blend of 60 percent stocks and 40 percent bonds is right for your $100,000 portfolio. And let's further assume that over the course of the next years, stocks earn 10 percent per year, and bonds earn 5 percent per year.

Assuming you reinvested all your gains and neither added nor withdrew any money, the stock portion of your portfolio would be worth $156,000, while your bond holdings would be worth $65,000 for a total portfolio value of $221,000. (For simplicity's sake, we're ignoring taxes.)

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But look. Not only is your portfolio bigger, it's also riskier. Why? Because you've gone from a 60 percent stocks -- 40 percent bonds to an allocation of 70 percent stocks ($156,000 divided by your portfolio value of $221,000) and 30 percent bonds ($65,200 divided by $221,000).

This change may not seem so drastic. But when stock returns were much higher in the late '90s, many investors found themselves with portfolios much more heavily tilted toward stocks then when they started out -- which only added to their disappointment when stocks hit a wall.

Of course, if bond returns outpace stocks returns by enough of a margin, your portfolio could become more bond-heavy, or conservative. The point is that by doing nothing you may letting your portfolio morph into something other than what you want it to be.

The way to avoid that is by rebalancing your portfolio, or fine tuning it to bring it back to (or pretty close to) its original portions (or whatever proportions are appropriate if your goals have changed since you set your original allocations).

Rebalancing also has another benefit: it forces you to do something investors all say they want to do but rarely have the discipline to pull off -- sell high and buy low. Think about it. If stocks have a great year and bonds tank, then the stock portion of your portfolio swells in value, while the bond part shrinks. To bring your portfolio back in line, you've got to sell some high-flying stocks and put the proceeds into cellar-dweller bonds.

Three strategies for rebalancing

Okay, so how should one pull off this rebalancing act? Basically, you've got three options:

CALENDAR REBALANCING: Here, you pick a time period -- a month, a quarter, a year -- and you bring your portfolio back to its original proportions at the end of that period.

It's difficult to say which time period would give you the best results in terms of return vs. risk. It really depends on how the various assets you're rebalancing move relative to each other, something that's next to impossible to determine in advance.

As a practical matter, however, I think annual rebalancing is probably the best option for most people since it requires the least effort and, therefore, is most likely to actually get done. It also has the advantage of generating lower transaction costs.

TARGETED REBALANCING: The idea here is that you set a range of, say, five to ten percentage points around your various allocations, and you then rebalance once the asset class falls outside that range.

So, for example, if your allocation is 60 percent stocks and you set a range of plus or minus five percentage points, you would rebalance once stocks grew to more than 65 percent of your portfolio or slipped to less than 55 percent.

This method prevents your mix from ever straying too far from your original allocation, but it requires more monitoring on your part and can lead to unnecessary trading and transaction costs if the market is bouncing up and down a lot.

TACTICAL REBALANCING: In this type of rebalancing, you incorporate your view of the market into the rebalancing decision.

So, you might set a potential range for your stock holdings of, say, 40 to 60 percent of your portfolio. If stock prices seem frothy to you, then you might rebalance your portfolio so your stock allocation falls back toward the bottom of that range. If, on the other hand, stocks seem cheap, you would rebalance to push your stock holdings toward the top of the range.

I'm sure you can make a case for any of these methods. But for most people I think simpler is better, and the method likely to generate fewer transaction costs generally better than others. To me, that adds up to calendar rebalancing on an annual basis.

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Walter Updegrave
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One final note: when rebalancing in taxable accounts, you should first try to rebalance by adding any new money to whatever part of your portfolio needs to bulk up. That way you can avoid or mitigate the tax you incur when selling winners.

You should also use rebalancing as a way to unload the dogs from your portfolio. After all, if you're going to the trouble to rebalance, you might as well revitalize your portfolio at the same time.


Walter Updegrave is a senior editor at MONEY Magazine and is the author of "Investing for the Financially Challenged." He also answers viewers' questions on CNNfn's Money & Markets at 4:40 PM on Monday afternoons.  Top of page




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Most stock quote data provided by BATS. Market indices are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer. Morningstar: © 2018 Morningstar, Inc. All Rights Reserved. Factset: FactSet Research Systems Inc. 2018. All rights reserved. Chicago Mercantile Association: Certain market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. Dow Jones: The Dow Jones branded indices are proprietary to and are calculated, distributed and marketed by DJI Opco, a subsidiary of S&P Dow Jones Indices LLC and have been licensed for use to S&P Opco, LLC and CNN. Standard & Poor's and S&P are registered trademarks of Standard & Poor's Financial Services LLC and Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC. All content of the Dow Jones branded indices © S&P Dow Jones Indices LLC 2018 and/or its affiliates.