The Art of the Rebalancing Bonus

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The Art of the Rebalancing Bonus

Portfolio design and rebalancing is both a science and an art. Understanding the science is akin to understanding the physics of why a spinning ball hooks and bends. The art is the execution of the science such as when you are actually playing soccer or golf. It is the execution and follow-through that produces the desired outcome.

Knowing that rebalancing boosts returns is useless unless you as the investor have the time, discipline, and nerve to follow through and actually strike the ball.

Rebalancing is the most helpful when it is most difficult. Rebalancing involves selling the investments that have appreciated and buying the assets that have recently gone down. We are biased to believe that recent occurrences will continue. When it comes to the markets, this instinct must be overcome.

This is one area where an investment advisor can add value. Even an advisor who does nothing other than help you set an asset allocation and then rebalance once a year might boost your returns by 1.6% over a buy and hold strategy. This rebalancing will also lower the volatility of your portfolio. Together, these bonuses help increase the likelihood that you will reach your retirement goals.

Yes, you could do this yourself, but many investors don’t. A few investors buy and hold investments while an even greater number chase returns, moving in the exact wrong direction. Even an advisor who only keeps you from chasing past performance might significantly boost your returns.

If you choose to rebalance yourself, you can accomplish this most easily by automating your rebalancing. Automatic rebalancing is most common in 401(k) accounts. If your account offers the feature, take advantage of it. If you must choose specific months or days to rebalance, we suggest May 1st and October 1st.

The important thing is to make sure your portfolio is regularly rebalanced. If the only available rebalancing method is Manual, the danger is that you will emotionally pick the time to rebalance which will be the exact wrong time. Instead, you should pick times of the year blindly and then stick with it.

That being said, receiving the rebalancing bonus requires that investors have an asset allocation in the first place. Most do not.

Your asset allocation definition matters. Rebalancing works best with non-correlated asset categories, like Emerging Market Stocks and U.S. Stocks. If you define your asset classes incorrectly, rebalancing between them may not help.

You should not define your asset class as one industry of the economy. One industry could lose value indefinitely as another industry rises to take its place. Rebalancing into a failing industry would only bring your returns down with it.

Meanwhile, you dodge this problem with broader asset class definitions. Technology, Basic Materials, and Manufacturing are good, broad definitions while VHS Rentals, Diamonds, and Buggy Whips are too narrowly defined and may fail you.

It is even better to have two levels of asset class definitions: asset classes, like U.S. Stocks and Resource Stocks, which are non-correlated categories and then sub-categories, like Technology, Basic Materials, and Manufacturing, which although they have some correlation are not highly correlated.

Lastly, some sectors such as Gold or Small Cap Growth are not on the efficient frontier. Including them in your asset allocation is simply the wrong move. Rebalancing to a poorly designed asset allocation will often mean moving money from categories which are on or near the efficient frontier into inefficient investments, hurting returns.

There is a great deal to be said about the method of rebalancing. Keeping transaction costs and capital gains taxes low when rebalancing also helps boost the return.

Funds with high expense ratios put a drag on returns. Even an index fund drops off the efficient frontier when the expense ratio becomes excessive. Rebalancing into bad funds also hurts your returns.

While the science and art of setting an asset allocation and regularly rebalancing back to it is not an easy discipline, it can boost returns by as much as 1.6% over a buy and hold strategy and even more over buying and chasing returns.

There is an art to rebalancing, but it is better to rebalance poorly than not at all.

Photo used here under Flickr Creative Commons.

Follow David John Marotta:

President, CFP®, AIF®, AAMS®

David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. In addition to his financial writing, David is a co-author of The Haunting of Bob Cratchit.

Follow Megan Russell:

Chief Operating Officer, CFP®, APMA®

Megan Russell has worked with Marotta Wealth Management most of her life. She loves to find ways to make the complexities of financial planning accessible to everyone. She is the author of over 800 financial articles and is known for her expertise on tax planning.