In this article you will find out more about:
What is Portfolio Rebalancing - Definition and Meaning of Portfolio Rebalancing
Which Types of Rebalancing Exist - How to Rebalance an Investment Portfolio
Why Portfolio Rebalancing is Important - Portfolio Rebalancing Benefits
What Happens to a Portfolio Without Rebalancing
How Portfolio Rebalancing Can Impact Portfolio Performance
Best Portfolio Rebalancing Strategies
When and How Often to Rebalance an Investment Portfolio
Costs of Portfolio Rebalancing and How to Keep Transaction Costs from Portfolio Rebalancing Low
Best Portfolio Rebalancing Tool
Further Interesting Reading about Portfolio Rebalancing
What Is Portfolio Rebalancing - Definition and Meaning of Investment Portfolio Rebalancing
Portfolio rebalancing describes the process of readjusting the asset allocation in a portfolio after some time to the desired initial weighting.
When setting up an investment portfolio, the investor decides initially on the desired weighting for the asset allocation. For example, a portfolio could be composed of 70% equity and 30% fixed income investments. This is in order to obtain a sufficient level of diversification as safety net and to control the risk level of the portfolio.
Over time, the portfolio allocation will change since equity and fixed income assets develop differently. For example, while equities may have performed very well, bond investments may have produced inferior returns. As a result, the initial asset allocation weighting in this situation will gradually drift towards a higher equity weight. For example, stocks could account for 80% of the total portfolio and the fixed income investment for only 20%.
How to Rebalance an Investment Portfolio - Different Types of Rebalancing
In order to readjust an investment portfolio to its initial asset allocation, there are two possibilities:
Selling – buying: Selling the position with a weighting exceeding the desired ratio and buying from the resulting cash-flow into the position with lower than targeted allocation weight (see graphic above).
Cash-Flow: Rebalancing an investment portfolio with cash-flow from dividends collected or additional cash deposits – the free cash is used to buy into the position with a lower than targeted allocation weight. No selling from the overweighted position is required.
Advantage of investment portfolio rebalancing from fresh cash-flow is that no profit tax is being triggered from selling assets.
When and How Often to Rebalance an Investment Portfolio
With regards to when to perform portfolio rebalancing, there are the following three options:
Calendar-based rebalancing: at a fixed date during a year, month or quarter the portfolio rebalancing is done - no matter how the markets are on that date. Depending on your broker's commissions and your personal investing style (one-off or regular saving plan): the more often rebalancing is done, the higher the transaction costs.
Threshold-based rebalancing: within a set tolerance threshold the portfolio allocation can drift (e.g., 10% deviation from initial target allocation). Once the threshold is breached, rebalancing is required. For example, if a 70/30 target allocation has drifted over time and the new allocation is 50/50, the investor should initiate adjustments back to the target asset allocation (70/30).
Calendar-based rebalancing if threshold is exceeded: is the combination of calendar-based and threshold-based rebalancing. The investor should review the portfolio allocation once a year and only rebalance if the allocation deviates more than the predetermined threshold (e.g., 5 or 10%).
Below video nicely summarises for a 70/30 portfolio allocation how to determine how much a portfolio needs to be adjusted in order to reach the initial target allocation again.
Why Portfolio Rebalancing Is Important
Although equities have outperformed bonds, the better return comes with a higher risk in the form of more volatility and drawdowns during market stress. To avoid a portfolio with higher risk profile, the equity allocation's overweight needs to be reduced to the baseline weighting of 70%: Rebalancing the portfolio is necessary. This returns the portfolio allocation to the original risk level.
The example below illustrates how the initial allocation ratio of 70% US stock market and 30% fixed income (here in the form of long-term treasuries) has shifted over time. The investment began in 1978 with a 70:30 allocation ratio. Without rebalancing, the equity allocation would have climbed to more than 90% in 2022, while the fixed income allocation would have declined to less than 10%.
How Rebalancing an Investment Portfolio Might Increase Returns
Rebalancing an investment portfolio may result in a higher investment return in the long run since the weighting of outperforming assets is reduced in favor of reallocating money to lagging assets. In the preceding example, the outperforming equity position is sold at higher prices and reinvested at a lower price level into the bond position. This anticyclical investing approach also keeps investors from attempting to time the market.
Looking at some of the metrics for such a 70:30 portfolio allocation, they developed as follows – without considering transaction fees and taxes:
Portfolio Rebalancing: Backtesting Results for Different Rebalancing Strategies
Portfolio Development with No Rebalancing
Due to the increased equity ratio over time, the portfolio experienced a max. drawdown of -41.78% during the subprime crisis (11/2007 – 03/2009) and -28.2% during the worst year. In the best year, the portfolio produced a return of +34.69%. The CAGR of 10.74% made of an initial investment of $10,000 in 1978 a final balance of $994,383 at the beginning of 2023.
Portfolio Performance with Annual Rebalancing
Once a year, the portfolio is readjusted to the initial 70:30 portfolio allocation ratio. Out of the four rebalancing strategies, the annual rebalancing led to 44 rebalancing transactions (every year between 1978 and 2023) – which can cause significant transaction costs and impact the return rate.
As the long-term treasury ratio was reset to 30%, the portfolio only saw a max drawdown of -33.21% during the subprime crisis (that is 10%-points less drawdown than without rebalancing!) and -22.6% during the worst year. In the best year, the portfolio returned +34.08%. The CAGR of 10.7% made of an initial investment of $10,000 a final balance of $976,100 till the beginning of 2023. Despite the lower final balance, the portfolio has a better risk-reward profile, as seen by a slightly higher sharp ratio (0.57 vs. 0.52).
Portfolio Performance with Threshold-Based Rebalancing
The asset portfolio is rebalanced if the absolute deviation from the target weighting is exceeding 10% - e.g., if 60:40 or 80:20 allocation ratio was exceeded.
Portfolio rebalancing was triggered eight times during the investment period 1978 – 2023.
Also, for this rebalanced investment portfolio the max drawdown during the subprime crisis was reduced from initially >40% (no rebalancing) to now -35.57% and -22,4% during the worst year. In the best year, the portfolio produced a return of +34.1%. The CAGR of 10.8% made of an initial investment of $10,000 a final balance of $1,018,092 till the beginning of 2023. This rebalancing strategy has led to the highest final balance of all four scenarios.
If the threshold for rebalancing is increased to 20%, the portfolio should be rebalanced as soon as - in our example - 50:50 or 90:10 allocation ratio was exceeded. Rebalancing was triggered twice due to an allocation ratio of 90.07:9.93 at the end of 1999 and in September 2002 at an allocation ratio of 48.34:51.66. Due to the higher threshold triggering a rebalancing, the portfolio experienced a higher max drawdown of -37.7% which is lower than for the strategy without rebalancing, but not too far away from the -41.78%. The drift to higher equity allocation ratio also led to a better return (CAGR of 11.14%) and higher final balance ($1,167,109). But clearly, this resulted in a higher risk profile of the investment strategy.
Is portfolio rebalancing a wise idea based on these backtesting results? What is the best portfolio rebalancing strategy for various investor types?
Best Portfolio Rebalancing Strategies
The best rebalancing strategy will depend on the individual portfolio allocation. If portfolio rebalancing is done on a regular basis, allocations of 60% to 80% equity may have the strongest impact on return. Because of the significant equity position, the maximum drawdown can be reduced, and the chances for higher returns increase.
For investors who check their portfolio on a frequent basis, the rebalancing strategy based on a 10% threshold may be most beneficial. However, this requires continual monitoring of the portfolio allocation to avoid missing the best moment for rebalancing activities. A higher threshold for the absolute deviation from the initial portfolio allocation will result in insufficient rebalancing, allowing too much drift away from the desired target allocation. On the other side, higher thresholds for triggering rebalancing actions allows investors to take advantage of market momentum.
How often Do You Rebalance Your Portfolio?
Never
Not regularly
Less often than a Year
Yearly
Less active investors will prefer the annual rebalancing on a fixed date each year (e.g., February 1st). There is no need to monitor the portfolio's development. On the date of rebalancing, the portfolio allocation is to be readjusted to the initial allocation ratio and that’s it. Annual rebalancing keeps transaction costs (both direct and indirect, such as broker commissions and spreads) low - both too-frequent and too-infrequent rebalancing are inefficient in terms of costs (too many transactions) and risk-return (drifting too far from target allocation). According to an assessment about the best portfolio rebalancing strategy made by Morningstar Direct in 2020, annual rebalancing is reducing disadvantages of too frequent rebalancing while maintaining an attractive risk-return profile (see illustration below).
Costs of Portfolio Rebalancing
For investors seeking a more convenient option, robo advisers and financial advisers offer automated rebalancing based on pre-defined rules for a small annual fee. Some well-established brokerage companies like InteractiveBrokers, provide a free portfolio rebalancing tool for automated portfolio rebalancing.
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How to Lower Transaction Costs
There is no need to pay a subscription for a portfolio rebalancing calculator or rebalancing software. Our Portfolio Rebalancing Tool will make regular portfolio rebalancing a breeze. Check the functionality of the portfolio rebalancing tool to learn how it will make your rebalancing process as smooth as silk.
There are also ready-made ETF's replicating a well-diversified portfolio of equities, bonds and sometimes also commodities. Vanguard, for example, offers such low-fee portfolio ETFs under the name Vanguard LifeStrategy. Investors can choose between different asset allocation models (e.g. 100% equity, or 80/20 equity/fixed income etc.), just buy the ETF and Vanguard is taking care of investing and rebalancing for below 0.3% TER per year.
Overall, it became evident why portfolio diversification is critical to achieving a better risk-return profile for a portfolio. The blog article "Why Portfolio Diversification Matters Even More Nowadays" discusses several recent examples that provide a compelling argument for why portfolio diversification is still super important for successful investing.
If you invest via a regular savings plan, simply modify the saving rate once to re-establish the desired portfolio allocation. There are no transaction costs to pay as many brokers offer free saving plans.
Further Interesting Reading about Portfolio Rebalancing
Dichtl, Drobetz & Wambach (2015): Testing rebalancing strategies for stock-bond portfolios across different asset allocations - comparing risk-adjusted performance of stock–bond portfolios between rebalancing and buy-and-hold across different asset allocations for the US, UK and Germany by reporting statistical significance levels.
Dichtl, Drobetz & Wambach (2014): Where is the value added of rebalancing? A systematic comparison of alternative rebalancing strategies - a study comparing the performance of different rebalancing strategies under realistic market conditions.
Horn & Oehler (2020): Automated portfolio rebalancing: Automatic erosion of investment performance? - analysing whether households would benefit from a service that automatically rebalances a portfolio.
YCharts White Paper (08/2021): What’s the Optimal Rebalancing Strategy?
Disclaimer: The scenarios or investment products presented above should not be construed as investment advice. All investments involve some level of risk, and past performance is never a guarantee of future returns. As always, do your own research in order to validate and better understand the underlying risks.