When should you rebalance your portfolio? It is often suggested that once a year will do the trick. Many will suggest every 6 months. But perhaps what makes the most sense it to rebalance when the portfolio allocations drift out of shape. This might allow you to buy low and sell high and take advantage of any price swings.
First off the most important component or task of rebalancing is to keep your portfolio’s risk level in check; to keep your portfolio within your personal comfort level for portfolio value declines. As an example, if your stock allocation glides from 60% to 80% the potential for the portfolio to decline in value in a major correction might increase from 25% to 35%. You’re now investing outside of your risk tolerance level.
Here’s an example using the TSX 60 XIU and iShares Core Bond ETF XBB. Courtesy of portfoliovisualizer.com, Portfolio 1 is 60% stocks and Portfolio 2 is 80% stocks.
And certainly sensible investing would include using greater diversification by also owning US and International stocks as well. You’ll find that approach on the ETF Model Portfolio Page on Cut The Crap Investing.
That significant level of portfolio drift could happen within a year so it’s likely best to keep an eye on the asset percentages compared to keeping an eye on the calendar. That’s also the suggestion in this Morningstar Portfolio Course.
Morningstar suggests that you might rebalance when any asset might diverge by 5% to 10% from original portfolio settings. And certainly more constant rebalancing might enable you to keep the portfolio risk level on track, but you might create unwelcome trading costs or tax events if you’re investing in a taxable environment.
The Tangerine Portfolios look to rebalance every quarter. That’s usually enough frequency. That said, the managers will only rebalance if necessary. They are also looking to keep the trading costs and tax events to a minimum. And they are successful on that count. The TER (trading expense ratio) is usually in the area of .01 or just 1 basis point annually for their core index-based portfolios.
Their high yield Dividend Portfolio will look to rebalance every 6 months.
Asset allocation portfolios such as the Vanguard One Ticket offerings will rebalance at the portfolio manager’s discretion when they see the portfolio’s assets drift. One of the main benefits of these one ticket offerings is that you do not need to worry about that rebalancing act – these are managed portfolios.
Rebalancing is more than risk management
We all know that ‘buy low sell high’ investment mantra and that is what will often happen when you undertake that regular rebalancing. And of course the stocks will often take the lead on that meaningful move to the upside.
Rebalancing can help you lock in your gains on the stock assets in periods when the stock markets are leading the charge. If we look again to that major correction of 2008-2009 stock gains were quickly wiped out to the tune of over 50% for many US stock funds. Here’s the US market through the recession demonstrated by iShares IVV fund that tracks the S&P 500.
We see that half of the stock value disappeared. If one held a balanced portfolio and was rebalancing in 2007 and 2008 they would have meant selling stock assets and moving those gains to the ‘safety’ of the bond component. The bonds become a store of value, they can help to protect your gains.
Here’s an example with a Balanced Portfolio model. For simplicity sake we’ll only use those US assets. The stocks are in that IVV fund, for the bonds we’ll use iShares Core Bond Fund – ticker AGG. All are in US dollars.
Here’s an example with the all equity portfolio as Portfolio 1, Portfolio 2 is the Balanced 60/40 model. We start with $100,000 in each portfolio.
Of course from 2005 start date (we gave it a little more runway) the bond component at 40% is $40,000. By the time the stock markets peaked in October of 2017 the bond component is at $50,000. While some of that increase in value is due to the bond fund eking out modest gains, most of that additional value is courtesy of the stocks and that rebalancing. For the period to October 2017 the US stocks had been delivering at an average of 11% per year. Some of the stock gains have moved to the bonds that hold less risk.
And then the tables turn
Bonds can certainly outperform stocks. And that’s not difficult perhaps when stocks are falling off of a cliff; the bonds don’t even need positive returns to ‘outperform’. That said bonds of higher quality and especially government treasuries are known to deliver positive returns when stock markets go in the tank. Bonds have done their thing in every recession.
Stocks go down. Bonds go up. I like to use a teeter totter analogy. As always, there’s no guarantee that history will repeat.
In a related post here’s one of my articles on Seeking Alpha on treasuries and that market insurance. There’s an incredible chart in that post that shows that mirror reverse image of stocks to bonds through market corrections.
Your bond monies can then go value hunting
What? And you thought your passive approach was not all that active. Your passive investment approach is going to go hunting?
Yup. Of course the ‘best’ time to buy stocks can be when no one wants them. As Warren Buffett reminds us we should be greedy when others are fearful. In the last recession bonds held up and then provided a modest ‘spike’. That rebalancing mechanism would have allowed an investor to buy the stocks (with bond proceeds) when the stocks went on sale. That is part of the magic of rebalancing.
And that rebalancing act can create a ‘value add’. The Balanced Growth Model can often match or beat an all-equity approach through a market cycle. We are not always rewarded for taking on the additional risk of an all-equity portfolio.
Here’s a look at the US stocks vs bonds in 2008 and into 2009. Portfolio 1 is bonds, Portfolio 2 is stocks. There was the opportunity for bond monies to buy low, to go value hunting.
And bonds don’t always need a market correction to perform well. On Seeking Alpha I wrote an article that suggested My Stinky Bonds Are Back From The Dead.
In that article you’ll see my Vanguard VAB has been moving up nicely. But is it a rebalancing opportunity? The Canadian and US stocks have been going up in value as well over the last year and especially year to date. Stocks and bonds can move up together and they can certainly fall together as well, at times. The rebalancing opportunity might be to move some monies from the stocks to those bonds that have been increasing in value.
The wonderful awealthofcommonsense blog posted an interesting article noticing the crazy and abnormal returns for bond funds. It’s a little more exaggerated in the US over the last year. And it made the author Ben Carlson think and question. Should he do something about and with this increase in bond value? Here’s Finance Topics That Make Your Head Hurt.
After exploring many options I was so glad to read that Ben landed on simple rebalancing as perhaps the most sensible option.
So if you wanted to trim some of your winnings in bonds and rebalance into stocks, that could be a prudent form of risk management to stay in line with your stated asset allocation targets. Of course, this would also mean you trimmed your stock holdings to put some of those winnings back into bonds at some point over the past few years.
Balance your risk level with your costs
Once again, there can be trading costs and you can create tax events. I am more of a fan of letting the portfolio drift. You might use that 5% to 10% band as a signal to take action. And the most important consideration is to keep your portfolio in line with your risk tolerance level. And keep in mind that your time horizon for an investment amount will affect the suitable asset allocation. A major shift may be in order at times. Here’s You should protect your portfolio long before your retirement start date. Of course we have to use that same consideration with our RESP funds. We want to move some of the monies to safety as the student approaches their start date and need for funds.
Here’s some more thoughts and a rebalancing spreadsheet courtesy of CanadianCouchPotato.
Here’s a very nice article from Preet Banerjee on MoneySense.
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