Yesterday, Matt reported on the latest in a string of academic studies that have called into question the traditional advice of annually rebalancing investment portfolios. It's important to recognize that these challenges to the conventional wisdom that periodic rebalancing is a good thing come from two different angles. On the one hand, some research indicates that in certain circumstances, a portfolio's overall returns may be reduced by rebalancing. Others focus on the fact that in certain types of market environments, rebalancing can actually increase risk, rather than decrease it (like the example in yesterday's article of rebalancing from bonds to stocks in the middle of a prolonged bear market in stocks).
While these points of view are true, it's easy for them to all kind of gel together into a broader "rebalancing is a bad idea" impression. We don't think that's accurate. For one thing, it's usually hard to identify exactly what type of market environment you're dealing with, which means many of these research findings are of limited value in making real-time decisions. It's one thing to know that rebalancing between stocks and bonds in the middle of a stock bull market can diminish overall returns. But are we in the middle of a stock bull market, or near the end, when it would definitely be to your advantage to pull your stock holdings back into line with your long-term optimal allocation? Everything looks clear in hindsight; the challenge is making decisions in real-time.
Because of this, we view rebalancing primarily through a risk-management lens rather than with an eye on optimizing returns. Does this mean we might give up some marginal returns because of rebalancing too often? It's possible, but we think for most readers it's still worthwhile because of rebalancing's potential to reduce risk (both financial and emotional).
One of the more underrated practical aspects of annual rebalancing — completely overlooked in most of the academic studies — is that annual rebalancing forces an investor to pause and take a big picture assessment of their portfolio. The act of rebalancing forces you to look (and hopefully think!) about the way you're fitting together the big pieces of your personal investing plan puzzle. For many, this may be the only time during the year that they really stop and think about whether their allocation between stocks and bonds, or among various strategies, is still appropriate given their current circumstances. That's a healthy thing in and of itself, as an investor who is confident in the fundamental decisions guiding their investing is much more likely to stick with their plan in times of market duress, thus avoiding the costly mistakes that undermine so many investors.
At this point, you're probably thinking I'm about to send you all off to rebalance those portfolios, pronto! Actually, I'll admit that the academic research findings of the past decade or so have made me a bit more mellow about the topic. What I mean by that is simply that I think it's less of a big deal if you don't tidy things up in your portfolio quite as perfectly or quite as often. For example, if you look at your stock/bond allocation and it's within, say, five percentage points of your ideal, you're probably fine leaving it alone for another year. Likewise, your mix between strategies (although the more aggressive the strategy — like Sector Rotation — the closer you probably want to keep it to your target).
In terms of the SMI strategies, Upgrading probably offers the most reason to rebalance every year, simply because we update the allocations for each stock and bond risk category every year. With those changes going on, it usually makes sense to go ahead and tweak your holdings to get in line at the beginning of each year.
The case for rebalancing with Dynamic Asset Allocation is probably a little looser, if only because it's so easy to rebalance "on the fly" with that particular strategy. DAA only owns three holdings at a time, so if you simply look at your percentages each time a holding is changed, it's easy enough to do a little rebalancing at those times. Of course, there's nothing wrong with rebalancing back to strict 33.3% holdings of each at the beginning of each year. But it probably isn't necessary if you're taking a rebalance-as-we-go approach there.
Just-the-Basics investors are probably safe using the rough 5% rule of thumb, where you can leave things alone as long as your portfolio allocations are still within about 5% of your ideal. If they're outside that range, go ahead and rebalance. It'll likely be your only transaction for the year in that strategy, so it's hard to complain too much about that!
Regardless of how you approach the rebalancing task each year, we still encourage you to go through the process of looking at all of your account and strategy balances, and think about whether your current mix is still the most appropriate choice for you. For most people the answer should be yes — generally speaking, a long-term plan should be just that and shouldn't be changing much from year to year. But there are exceptions: you find that you're further along toward your goals than you realized (or further behind), your life situation has changed significantly, etc. Even if you're not technically rebalancing this year, this portfolio-assessment process certainly has value and should be done at least annually.
If you're not quite sure how to go about this rebalancing process, the article Is Your Portfolio Out Of Balance? from the January 2014 issue of the Sound Mind Investing newsletter is a great place to start.