A year in the life of the stock market can be brutal. Daily swings up and down are unpredictable at best, but we’ve seen that rebalancing can help smooth out some of this volatility. There is a lot of argument on whether it actually increases your earnings or not, but it all depends on your asset allocation. If you’ve decided to go the rebalancing route, the next thing you need to decide is when to rebalance.
The +/- 5% Band Method
A popular method is the +/- 5% rule, which says that you should rebalance when one of your asset classes goes up or down by 5%. So if your desired AA is 80% stocks and it moves up to 85%, you would rebalance your account by selling some of your stocks and buying more bonds. Although 5% doesn’t seem like a lot it takes a tremendous drop/rise in stocks to shift your portfolio by 5%. I think people get a little too excited with rebalancing and tend to rebalance way too often.
A Large Drop In Stocks
Courtesy of The Finance Buff
I pulled this chart from another great personal finance blog that I read weekly. It shows the required drop in stocks to reduce your allocation by just 5% depending on your portfolio’s allocation to stocks. From about 25-80% stock allocation, the required drop in stocks is around 25%. The stock market rarely drops 25% in one year, so you can see how infrequently you’ll need to rebalance based on this method(most investors are probably in the 25-80% stock allocation range).
Can You Rebalance Too Often?
I think it’s a common misconception that you should rebalance quarterly, bi-annually, etc. In fact, the more you rebalance the worse off your portfolio could be in certain situations. I’m not sure who propagated this theory, but I could see why a financial advisor might advocate it. It’s in the best interest of an advisor to have you rebalance your portfolio once or twice a year for a small 1% fee
John Bogle(founder of Vanguards) has shown that certain portfolios will perform the same whether they are rebalanced or not. Although this is a very specific case, and not representative of every situation, it reiterates the fact that rebalancing aims to reduce risk. We know that rebalancing too much can be harmful to a portfolio, but is the risk-return of never rebalancing worth it? I don’t think so. So where is the sweet spot that allows investors to maximize returns with a manageable amount of risk? Well it’s impossible to tell and I actually haven’t seen a +/- 5% drop in the stocks portion of my portfolio yet so I haven’t actually used that method(yet).
I take an in-depth look at my accounts once or twice a year and I’ve found the best time to rebalance for me is when I make my annual Roth IRA contribution. Since it’s a large lump sump($5,000) I make sure to re-assess my portfolio and rebalance to my desired AA of 90% stocks/10% bonds. I think the sweet spot is a combination of the +/- 5% and annual rebalancing. In the future though, I’ll be contributing to my Roth IRA every two weeks so I’ll have to refine this method a bit.
Rebalancing isn’t a ton of work but in my next article, I’ll show how I do it simply and effectively. I have a couple intuitive spreadsheets that I’ll share with you to help you rebalance efficiently.
Readers, how often do you rebalance? Do you use the +/- 5% band method, annually or something completely different?
-Harry @ PF Pro