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Rebalance? Yes, but When? - Second Quarter, 2008

Jeff White

So the roller coaster ride that is the US stock market has started back up again.  This has probably left your portfolio in some disarray.  Your current allocation may not look anything like your target allocation.  If it is far enough away, most academic studies would tell you to rebalance your portfolio back to your target allocation.  The next question is "how far away is too far?"

Some rebalancing recommendations are based on time - either monthly, quarterly, yearly, etc...  Others are based on some "trigger" - an allocation percentage threshold amount.  Meaning, when your actual allocation is more than "x" percentage points away from the target, it is time to rebalance.  Say your large cap growth target allocation is 20% and your current allocation is 26%, if your trigger percentage is 5%, then you would rebalance.

By rebalancing, you are taking money from those assets that have done well and moving it to ones that have fallen behind in order to bring all of your investments back into the right proportions in the portfolio.  This may seem counter intuitive, but in fact it is quite the opposite.  It is a classic example of "buying low and selling high."  You are selling at the high of an asset and are buying one at a low point, but poised for a comeback. 

Back to the question of how far do you let your portfolio run.  By rebalancing your portfolio, you reduce your volatility (as measured by standard deviation) and increase your return.  For some portfolios, a 10% trigger is slightly (emphasis on slightly) better than a 5% trigger (better meaning lower standard deviation and higher annualized return).  And, 15% is better still - but not by much.

So, should you use a 10% or 15% trigger?  No.  At some point, you put time, energy and a lot of thought into developing your specific target allocation.  This allocation takes into account your investment time horizon, your tolerance for risk, any cash flow needs, etc…  If you use a 10% or 15% trigger for rebalancing, you are de-emphasizing your target allocation.  If you let one investment get to 15% away from your target, then your portfolio looks nothing like the target.  You have changed your risk profile and overexposed yourself to one segment of your portfolio. 

One of the key reasons for having a target asset allocation is to appropriately diversify your portfolio.  By letting your winners run unchecked, the diversification is degraded.  Imagine if you had let your high tech fund run during the bubble of 1999.  If you had rebalanced it at a 5% trigger, you would have been better off when the bubble burst.

A 5% trigger allows for some pick up in return and a reduction of volatility without sacrificing the diversification and benefits of the target allocation.
At InvesTrust, we strive to help our clients develop and  maintain a consistent approach to rebalancing.  If we can help you with this issue, please let us know.

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