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  • Rebalancing question

    So I've been playing a little catch-up on the financial literacy front, and there's a question that's been bothering me a bit re: rebalancing.

    I get the pros: it keeps your asset allocation on point, and it forces you to sell high/buy low.  But it also seems like there are a fair amount of cons also: rebalancing seems like a form of churn that will increase your taxes as well as add whatever brokerage fees you accumulate.

    What general guidelines do people use for rebalancing?  When, how often, etc?

  • #2
    Welcome, veritablpenguin!

    Most people who rebalance use a time-based or threshold-based system for choosing when to rebalance. This is something that you should decide upon and stick to as part of your IPS or Investor Policy Statement so that you consistently follow a set of rules instead of haphazardly rebalancing.

    A time-based system more straightforward: you pick an interval of time and you rebalance at that interval. This interval varies widely, but I'd say most frequently I hear 6 months to 1-2 years. However, there are some people who rebalance way more frequently. I don't have references, but studies have shown that rebalancing every 1 year to 18 months or so is ideal. Generally, that lets an asset that is outperforming time to outperform and build upon that for a little bit (i.e. the idea behind the momentum factor).

    A threshold-based system involves choosing rebalancing bands. The most common one that I stumble upon is the 5/25 rule. You rebalance if an asset is off from target by an absolute percentage of 5%. For example you want 25% in Total Int'l Stock Market and it has increased to 30%, that would trigger a rebalance event to get it back down to 25%.

    The other part of this is for assets that make a smaller percentage of the overall allocation and whose total allocation may only be 5% (therefore, if off by 5% in absolute terms, they would be up 100%). Therefore, the other rule is to rebalance if a smaller asset is off from target by a relative percentage of 25%. So if you had 5% in Emerging Mkts and it has increased to 6.25%, then it would trigger a rebalance event to get back down to 5%.

    If you have taxable accounts, then yes, this involves selling assets (and potentially locking in capital gains) and also incurring trading fees. First, use a low-cost brokerage. Vanguard (and I'm sure others) give you free trades, especially if using in-house funds. Second, I say potentially lock in gains because if you have a taxable account you can also be tax-loss harvesting and offset gains with prior losses (and if one asset is going way up and you are well diversified, then likely another asset is having a rough time). Having set rules laid out in your IPS (like I mentioned at the beginning) means you only rebalance when conditions are met.

    All that being said, I do not yet have a taxable account so don't have to worry about those issues at this time. Hopefully I didn't mess up any of the basics in that last paragraph.

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    • #3
      I rebalance our retirement accounts every year on our birthdays. Stick to your IPS. If you don't have one, make one. Not too time consuming to make although a lot of research could be done reading about the best way to do it. This was easier when my wife and I had similar investment options and contribution rates in our accounts that I had it set up to do it automatically. Now since she has access to both 403b/457b, her accounts grow twice as fast as my 401k so I do it manually on her birthday every year.

      You can also rebalance by changing your elections. E.g. if international % has dropped below target allocation for the past year in your taxable, maybe next time you contribute to taxable buy more of your international stock. Certainly it gets more complicated with a taxable, but if you only have tax deferred space, it's a lot simpler.

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      • #4
        I would rebalance by adding new money in, not selling.  This can be done on a more regular basis, not allowing too much deviation from your desired AA, instead of doing it when you're 5% off or every 5 years or something.  Requires more of a close watch on things if you have smaller amounts to put in, but if you're able to contribute a lot at a time may be something you can do at wider intervals.  No sense in selling and incurring taxes.  Also, watch out for buying into funds after the ex-div date.  You'll take the dividend distribution hit but not get it back.  This is why I don't like automatic investing to some degree.

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        • #5
          We rebalance client accounts annually beginning in August. No particular reason for that month, it's just when we began doing it. Yes, there will be tax effects, but you should keep your eye on the overarching goal, which is growth of wealth.
          Working to protect good doctors from bad advisors. Fox & Co CPAs, Fox & Co Wealth Mgmt. 270-247-6087

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          • #6
            Thanks all for the replies.

            ENTdoc, this is kind of how I had been approaching the issue before becoming familiar with the official concept of rebalancing.  So I guess that is part of my question.  Is buying underperforming sectors of your portfolio to keep your asset allocation where you want it, enough?  Or is the selling overperforming areas independently important?

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            • #7
              Yes, buying underperforming assets is enough if it gets you to your target allocation. If it doesn't, then consider selling the overperformers to make up the difference.

              Selling overpeformers isn't independently important for rebalancing (esp if just directing new contributions to the underperformers gets you on goal). It's all in relation to your overall asset allocation. More generally, you want to sell high and buy low (unless TLHing).

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