The Importance of Rebalancing in Asset Allocation

  by Shelley Seagler

Investors love to idolize stock pickers like Warren Buffett and Peter Lynch, but few have the knack for betting their entire portfolio on a handful of companies. Most investors are better off investing in a diversified portfolio of assets, and when you do that, asset allocation becomes the single most important decision that affects your risk and return.

Let’s take a look at why asset allocations matter, how rebalancing keeps them on track, and the best strategies to rebalance your portfolio over time.

Why Asset Allocation Matters

Asset allocation is the way that you divide your portfolio among various asset classes. For example, you may allocate 85% of your portfolio to stocks and 15% of your portfolio to bonds. These high-level asset allocations can be broken down into specific subsets, such as large-cap versus small-cap stocks or short-term versus long-term bonds.

While investors like to focus on stock picking, asset allocation is a far more important decision. Vanguard researchers found that asset allocation accounts for 88% of all volatility and returns. In other words, in a diversified portfolio, the specific stocks or bonds that you choose matters less than the percentage of your portfolio in each asset class.

The ideal asset allocation for your portfolio depends on your risk tolerance, investment goals and time horizon. If you’re close to retirement or risk-averse, you may want a much more conservative asset allocation (think bonds) than someone that’s just entering the job market or ambitious (think stocks). There’s no one-size-fits-all model that works for everyone.

Rebalancing Keeps Asset Allocations on Track

Rebalancing is the process of maintaining your desired asset allocation over time. For instance, you may decide that you want 85% of your portfolio in stocks and 15% of your portfolio in bonds. If stocks outperform bonds this year, you may end the year with 90% stocks and 10% bonds. The rebalancing process restores the balance to 85%/15% through buying and selling.

Rebalance Portfolio

Comparing Rebalanced vs. Non-Rebalanced Portfolios – Source: Vanguard

Vanguard researchers found that rebalanced portfolios produce more return per unit of risk than non-rebalanced portfolios as measured by the Sharpe ratio. In the chart above, it’s clear that rebalanced produces higher Sharpe ratios (better) than non-rebalanced portfolios, even when accounting for risk. It’s an easy way to increase your risk-adjusted returns!

Strategies for Rebalancing Your Portfolio

The process of rebalancing a portfolio is really quite simple on the surface — you sell outperforming assets and use the proceeds to buy underperforming assets. Of course, there are many variables that complicate the process. You must weigh the benefits of improved diversification against the potential tax implications and the cost of commissions.

Download our free Checklist of Rebalancing Strategies to see all of the options for rebalancing your portfolio and maintaining an ideal asset allocation.

There are two strategies that investors use to rebalance:

  • Time-based Rebalancing involves rebalancing a portfolio on a regular basis (e.g. monthly, quarterly or yearly). Most investors are content rebalancing on a yearly basis since they can lock in the tax benefits and minimize transaction costs.
  • Tolerance-based Rebalancing involves using tolerance bands, or preset percentage changes (higher and lower), to trigger rebalancing transactions. If there’s a big swing in asset allocations mid-year, this strategy ensures your portfolio is rebalanced in a timely manner.

Vanguard researchers found that there’s little difference in what strategy you use to rebalance so long as you’re regularly rebalancing your portfolio. As a result, most investors prefer to rebalance on an annual basis to minimize their own time commitment, capture the potential tax benefits, and minimize any transaction costs.

Best Practices to Keep in Mind

There are several ways to minimize the cost of rebalancing a portfolio while still capturing all of the benefits. While these techniques don’t apply to every case, they’re helpful to know in case you find yourself in a situation where you can minimize the cost of rebalancing and achieve other goals, such as a charitable contribution.

Don’t forget to download our free Checklist of Rebalancing Strategies to see all of the options for rebalancing your portfolio and maintaining an ideal asset allocation.

Some of the most common techniques include:

  • Rebalancing in tax-advantaged accounts (think IRAs) is tax-free since you’re not withdrawing any money. In most cases, it’s best to rebalance these portfolios and leave taxable accounts untouched to avoid triggering any taxes.
  • Selling shares with a higher cost basis when rebalancing taxable accounts is a good way to reduce your tax burden without increasing risk exposure.
  • Using portfolio cash flow, such as dividends, required minimum distributions (RMDs) or new contributions, can lower the cost of rebalancing by eliminating the need to sell assets that you wouldn’t otherwise be selling.
  • Gifting assets via a qualified charitable distribution (QCD) enables you to support your favorite causes, avoid capital gains tax, secure a tax write off, and rebalance your portfolio — all at the same time!

It’s a good idea to speak with your accountant or financial advisor when discussing these options since the cost/benefit of charitable contributions, cost basis calculations, and other considerations can be challenging to work through on your own.

The Bottom Line

Asset allocation is the single most important investment decision you’ll ever make. Once you’ve made a decision, it’s important to keep asset allocations on track using rebalancing strategies. Smart strategies can help reduce the cost of tax and commissions, while maximizing the benefits of diversification to help you reach your financial goals.

If you’re looking for a way to increase your income in retirement, the Snider Investment Method provides an alternative to fixed-income investments. The strategy involves selling covered call options against a portfolio of stocks, enabling you to realize the benefits of stock ownership along with a regular income to support retirement.

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