Portfolio Rebalancing

What is portfolio rebalancing? Rebalancing is simply making the trades necessary to bring your portfolio back in line with your target asset allocation.

Why is it necessary to rebalance my portfolio? Most importantly, rebalancing keeps your portfolio consistent with your risk profile. A retiree that relies on his or her portfolio for income shouldn’t be invested in 90% stocks, and a 25 year old who won’t retire for at least 30 years shouldn’t be invested in 90% bonds. Market movements can dramatically alter your asset allocation over time, so it’s important that you periodically check your portfolio to see if rebalancing is necessary.

Rebalancing also has the potential to increase the return of your portfolio while lowering its risk. While there is certainly no guarantee that this phenomenon will occur, properly executed rebalancing plans within well-diversified portfolios have been shown to increase annual returns by small amounts (less than 1%). The example below illustrates a scenario in which excess returns from rebalancing would occur.

Finally, a rebalancing program establishes good investing habits. It may seem difficult or counterintuitive to sell an asset that’s performing well (or to buy an asset that’s performing poorly), but that’s exactly what you should do. Rebalancing forces you to buy low and sell high! If this is unclear, see the example.

How often should I rebalance my portfolio? There is no magic time interval at which you should rebalance your portfolio. As stated above, the primary purpose of rebalancing is to ensure that your asset allocation is in line with your risk profile, so we suggest checking your portfolio at least annually and more often during times of extreme market volatility. If you have a reliable rebalancing system (e.g., checking your portfolio every January, or the month of your birthday), there’s no need to change your routine.

If, however, you’re looking to establish good rebalancing practices for the first time, you may want to try setting bands around your desired allocation percentages. When an asset’s percentage goes out of band, simply make a trade to bring it back in. A good place to start is a range of about +/- 10% of the percentage in question. For example, if you had a 50% bond allocation, you would buy more bonds when your allocation got down to 45% (0.9*50%) and sell bonds when your allocation got up to 55% (1.1*50%). By using rebalancing bands instead of a set time interval, you can check for the need to rebalance whenever you look at your portfolio, not just one arbitrary time each year.

Another consideration is tax efficiency. Ideally, you would perform rebalancing trades in a tax-sheltered account such as an IRA. If this isn’t possible because the vast majority of your holdings are in a taxable account, you may want to rebalance less often (widen your rebalancing bands).

How do I rebalance my portfolio? Rebalancing your portfolio involves a few basic steps:

     1) determine an ideal mix of investments (Need help? Get a Personalized Portfolio Recommendation)
     2) set target bands around your allocation (described above - see "How often should I rebalance my portfolio?")
     3) periodically check your portfolio to see if your asset allocation is within the prescribed bands
     4) if necessary, make the trades to bring your assets back into band

If you are regularly contributing to (or withdrawing from) your portfolio, rebalancing simply involves buying the under-weighted (or selling the over-weighted) assets in your portfolio. If you aren’t a regular contributor/withdrawer, you will need to periodically check your portfolio’s balances, compare them to your ideal portfolio, and, if necessary, rebalance by exchange (sell one fund and buy another fund with the proceeds).

Several financial software programs allow you to easily download and view your current asset allocation, and Vanguard (see Why Vanguard) provides a similar service through its Portfolio Watch feature. If you prefer to track your own investments and are comfortable with Microsoft Excel, you may want to download one of our free rebalancing tools. Click on the link below for more information.

Portfolio rebalancing tools The following spreadsheets can be used to manually enter your portfolio holdings and check to see if rebalancing is necessary. In order to use these tools properly, Microsoft Excel must be installed on your computer and you should feel comfortable performing basic tasks in Excel. These files are provided free of charge and are meant for educational purposes; additional calculations will be required in many cases. To download either tool, click on the appropriate link below and save the file to your computer. For full functionality, be sure to enable Macros when prompted.

Beginner Rebalancing Tool (Microsoft Excel file)
Advanced Rebalancing Tool (Microsoft Excel file)

Rebalancing example The following example is meant to illustrate a scenario in which portfolio rebalancing would lead to excess returns. Keep in mind that rebalancing does not guarantee excess returns; its primary purpose is to maintain a risk-appropriate allocation. This example is completely hypothetical and is not intended to represent any particular time period.

Let’s say that two people, Rebalancing Rick and Forgetful Fred, each start out with risk-appropriate portfolios of 50% stocks and 50% bonds on January 1 of year 1 (seen below in left-hand box). After a great year of stock market performance (stocks up 50%), each man’s allocation becomes 60% stocks and 40% bonds. This portfolio is too risky for either person, so it’s time to rebalance. Let’s compare the investment returns of Rick, who rebalances to 50% stocks/50% bonds on January 1 of year 2 (upper right-hand box), and Fred, who forgets to rebalance (lower right-hand box).

Both Portfolios in Year 1
	Jan 1, Year 1		Dec 31, Year 1
		(a great year for stocks - up 50%!)
Stocks	$10,000 (50%)		$15,000 (60%)
Bonds	$10,000 (50%)		$10,000 (40%)
Total	$20,000		$25,000

Rebalancing Rick's Portfolio in Year 2
	Jan 1, Year 2		Dec 31, Year 2	Two-Year Annualized Return
	(rebalanced)	(a bad year for stocks - down 30%)
Stocks	$12,500 (50%)		$8,750 (41%)
Bonds	$12,500 (50%)		$12,500 (59%)	3.08%
Total	$25,000		$21,250

Forgetful Fred's Portfolio in Year 2
	Jan 1, Year 2		Dec 31, Year 2	Two-Year Annualized Return
	(didn't rebalance)	(a bad year for stocks - down 30%)
Stocks	$15,000 (60%)		$10,500 (51%)
Bonds	$10,000 (40%)		$10,000 (49%)	1.24%
Total	$25,000		$20,500

As you can see from the two-year annualized returns shown in blue above, Rick's rebalancing made quite a difference! By selling stocks (the high-performing asset) and buying bonds (the low-performing asset), Rick brought his portfolio back in line with his risk capacity and forced himself into a buy low/sell high transaction. For his efforts, Rick’s two-year annualized returns were almost 2% better than Forgetful Fred’s.