Adviser Investments Fund Update: Portfolio Balancing Revisited

Portfolio Balancing Revisited

January 24, 2019

Portfolio Rebalancing Revisited

Many investors use a new year as an occasion to rebalance their portfolio. But is regular rebalancing really necessary?

Perhaps not, judging simply by its impact on returns: Last fall, we analyzed two rebalancing strategies recommended by Fidelity and Vanguard, time-dependent and portfolio drift. After putting the data through its paces, we discovered that over nearly three decades, there was little difference in returns between periodic rebalancing, adjusting for portfolio drift greater than 5% or 10%, and never rebalancing. (Please click here for more portfolio rebalancing details.)

Of course, there’s more to rebalancing than sheer impact on returns. For those of you considering this move, we’ll go over rebalancing’s role in risk prevention as well as the taxes, trading fees and other costs incurred by the rebalancing strategies we analyzed.

Managing Risk

Prominent advocates of rebalancing (fund companies like Vanguard and Fidelity among them) often argue that it teaches investors discipline, forcing them to sell winners high and buy market laggards at a discount. By sticking to a strictly defined allocation between stocks and bonds, you can manage the overall risk or volatility of your portfolio continuously through market cycles.

Statistically, this is true. A portfolio that’s regularly rebalanced typically exhibits lower volatility. This results in better risk-adjusted returns over time, even if total returns closely resemble a never-rebalanced portfolio. But investors need to determine for themselves how much that risk control is worth to them—it comes at a price.

Trading Isn’t Free
Perhaps the biggest negative about becoming a rebalancing fanatic? Cost. When conducting our analysis in November, we assumed that every distribution was reinvested along the way, and didn’t include the potential impact of transaction fees or realized gains from trades. These are critical issues when considering a rebalancing strategy.

Any time you rebalance a taxable portfolio, you should carefully review how the various transactions you’ll make will impact your tax return on top of any fees you might incur.

Ask yourself:

  • Do funds in your portfolio have front- or back-end loads or short-term trading fees?
  • Does the fund you’re buying make regular distributions? (Some funds pay annually; others quarterly or monthly.)
  • Will selling your shares of a fund create a taxable gain? (This is not an issue in tax-deferred accounts like IRAs and 401(k)s.)

Thinking through these questions may help you realize how quickly the hidden costs of rebalancing can suck the wind out of your portfolio’s sails.

Still, merely buying and selling funds in your portfolio on a fixed schedule or when allocations get out of whack are not the only ways to rebalance. One simple idea is to direct any distributions or new investments into the under-allocated funds in your portfolio.

If you’re using the portfolio for income, you could sell more of your winners’ shares to reduce their allocation. (This will create its own tax liability, but you can’t avoid taxes forever if you’re drawing down your portfolio.) These techniques keep taxes and expenses down, unlike making numerous trades over the course of a year.

Keeping a Level Head

Something not to be overlooked when considering rebalancing: You’re only human. Rebalancing a hypothetical portfolio is easy. Many investors find it tougher to act when their own money is on the line. Rebalancing requires you to reward the losers in your portfolio while reducing your exposure to recent winners.

If you have a fund in your portfolio that’s been outperforming month after month, you’re probably not going to be in a rush to sell it to invest more in a fund that’s lost you money. But the central theory underpinning rebalancing requires you to do just that. Not just once. Over and over again. As Vanguard founder Jack Bogle once put it: “If you are going to rebalance, you have to be absolutely clinical, or you are better off not doing it.”

You could, of course, take the more relaxed approach and rarely rebalance—if at all—as long as you can stomach the increased volatility that is part of an “unbalanced” portfolio. Indeed, when you consider the bill from Uncle Sam that results from frequent trades, you could come out substantially ahead. As our analysis shows, when it comes to returns, going with the flow can be a good idea. That’s why the Adviser Investments’ investing philosophy is to make strategic trades when opportunities present themselves, rather than engage in regular or systematic trades (unless it’s something specifically requested by a client to meet their financial or investment needs, of course).

Some final considerations, if you do choose to rebalance:

  • Tracking Allocations. Before you rebalance, make sure your target allocation is appropriate. Do you still have the same investment goals as when you started? Has your risk comfort zone changed? Over a decades-long period like the one we examined last time, your initial allocation may no longer be a good fit, requiring periodic adjustments to the underlying mix of stocks, bonds and cash you rebalance back to.
  • Dealing With Paperwork. Be prepared for the hassles of making multiple trades per year. While most firms allow you to make trades online, you’ll have to review more paperwork and track every change to make sure there weren’t any errors (on your part or the fund company’s). This could add up to a lot of extra work and time.
  • Regular Monitoring. If you’re following a portfolio-drift scheme, you’ll need to stay on top of your portfolio and trade at the right times. As we showed last time, you could be in for both flurries of trades over a short period of time and years of sitting on your hands following this strategy. Since there’s no routine, you’ll need to pay close attention—day in and day out—to execute at the right times.

So is rebalancing necessary? Despite what the financial press or your fund company may claim, when you examine the evidence there is little benefit to returns, and only modest benefit to risk exposure. (Again, that’s assuming no tax consequences or trading fees.)

That said, if rebalancing regularly provides peace of mind and you’re willing to be clinical about it, your portfolio may not suffer too much for it either.

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Vanguard Founder John C. Bogle: 1929–2019

Vanguard founder Jack Bogle died from cancer on Wednesday, January 16 at the age of 89. Bogle’s vision in launching Vanguard in 1975 and his advocacy for individual investors over the years since have had a tremendous, positive impact on the mutual fund industry. The move to make funds more shareholder-friendly by cutting costs benefited all investors, as Vanguard’s competitors responded with their own fee cuts over time. Today, some companies offer index funds with zero operating expenses.

While Bogle may be known as the “Father of Indexing” for debuting the first consumer index fund, it was the application of Bogle’s low-cost mantra to actively managed funds that first caught our attention. We have long believed in “buying the manager, not the fund,” but bundling promising stock- and bond-pickers and industry-low expenses is a compelling proposition that has served us (and our clients) well over the years.

We did not always agree with Bogle’s investment recommendations or market calls, but Adviser Investments and investors worldwide owe him a debt of gratitude for his efforts to make investing more affordable for the individual and for tirelessly promoting the idea that the shareholder—or client—should come first.


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