Financial advisors often make things sound more complicated than they are. Even when unintended, their reliance on jargon can create confusion. One term thrown around a lot is ‘Portfolio Rebalancing’. While building our robo-advisor, Paasa had to unpack what rebalancing truly means.
John Templeton, among others, made rebalancing a cornerstone of his approach. Templeton used an early version of the cyclically adjusted price-to-earnings (CAPE) ratio to estimate valuations for the overall U.S. stock market. Essentially, his advice was: if valuations are too bubbly, sell; if less bubbly, buy.
And you guessed right: he is the Templeton in Franklin Templeton.
Rebalancing, in a nutshell
So what is rebalancing? You’ve picked a portfolio that has a certain allocation - say it’s a 90-10 portfolio (90% equity, 10% bonds). Over time, the portfolio drifts away from that allocation - perhaps after a long bull cycle, the composition is now 95-5. ‘Rebalancing’ brings it back to the original allocation. An advisor would ‘rebalance’ in order to normalize the allocation back to 90-10.
Why do we bring it back?
The simple answer is you don’t want to take on too much or too little risk. You want to take on the level of risk you agreed to take.
When your portfolio shifts from 90-10 to 95-5, you become overexposed to equity. This means the portfolio is more volatile - more risky - than you had initially started off with. So when the market corrects, a 95-5 portfolio will get hit harder because there’s lesser cushion from the bonds and more swing from the equity.
For investors, the alpha often lies in 1) how and 2) when the rebalancing happens. This, empirically, is the difference between a good and bad financial advisor.
How should I rebalance?
- Sell here, buy there: You use the proceeds from a sale of one asset to rebalance your portfolio. If you’re selling at a profit, i.e, paying capital gains tax, you should avoid this method unless absolutely necessary.
- Draw money from bank: Not so bad if you have dry powder (uninvested cash).
- Use dividends: Second best way to rebalance. You’re not dipping into your bank account - just effectively using the dividends from your existing holdings.
- Tax Loss Harvesting (TLH): Best.
Example: Suppose your equity allocation drifts from 60% to 70%. To rebalance, you identify underperforming stocks within your equity holdings and sell them. The losses offset gains elsewhere, minimizing the tax impact, while the proceeds fund the bond purchases needed to restore balance.
So according to Paasa’s Hierarchy of Rebalancing ∆:
Tax-loss harvesting first. No more tax to harvest, use dividends. No dividends left? Use uninvested cash from your bank. Don’t want to? Okay, shuffle your assets.
When should I rebalance?
Fixed period
Fixed-period implies the rebalance happens every month, quarter, half-year.
The key here is frequency. Ideally, the frequency would align with market cycles. Too much rebalancing could take away the gains, especially if there are transaction costs. Too little rebalancing could worsen the ‘drawdowns’ (another term for downswings).
You want your fixed-period rebalance frequency to ideally coincide with the market cycles. So you rebalance just before the down trend or up trend starts.
Data Point: A Morningstar study found that quarterly rebalancing balances returns and risk more effectively than monthly or annual rebalancing in most cases.
Drift band
This method ignores the calendar. Instead, it focuses on how much your portfolio has deviated from the target composition. For example, if your equity allocation is off by ±5%, rebalance!
Empirical evidence: a 10% drift-band for a 60-40 portfolio performs best, while a monthly rebalance performs worst. Source: YCharts on NASDAQ
Paasa uses a ±5% drift-band to rebalance.
Limitations of rebalancing
Let your winners win
Many investors sold NVIDIA too early when it surged from 10% to 40% of their portfolio. You might think, “If it’s going up, then why don’t you let it go up.” This sounds reasonable. But this is hindsight bias: most stocks don’t trend upwards indefinitely.
However, overbalancing can stifle growth. Broad Market ETFs might benefit from regular rebalancing, but for concentrated bets (like NVIDIA or angel investments), rebalancing could reduce outsized gains. Venture capitalists often write-off most investments, relying on a single winner to return their entire fund. Rebalancing is clearly counterintuitive in such cases.
If you think you have a potential winner in your portfolio, evaluate fundamentals and market outlook before agreeing to an algorithmic rebalance.
I didn’t know they were related!
A diverse portfolio typically includes assets with varying degrees of correlation. Equities and bonds are usually uncorrelated, except during times of economic stress, like when inflation and real interest rates are both high. In these cases, they can move in sync.
In such cases, you might want to reconsider your entire portfolio composition rather than just rebalancing.
Transaction Costs
Frequent rebalancing incurs trading commissions, which can eat into returns. While Paasa offers zero-commission transactions, investors should still generally be cautious of overtrading.
Final thoughts
When done systematically, rebalancing helps prevent your investments from becoming suboptimal. At the same time, recognize situations where rebalancing might not be appropriate or when you need to rethink your portfolio strategy altogether.
So, (how) do you rebalance?
