Updated Oct, 2021

Portfolio maintenance – rebalancing

rebalancing

Why rebalance?

Your tolerance market risk is based on:

  • Your ability to take risk – if you take this amount of risk and things go badly, is there enough time and income to start again and reach your goal before you need the money?
  • Your willingness to take risk – how are you going to react when things don’t go well?
  • Your need to take risk – how much risk do you need to take to reach your goal.

Rebalancing your portfolio is about bringing your portfolio’s risk back in line with what you can tolerate.

Imagine that you determined you may panic sell when your $1,000,000 portfolio fell by over $300,000, and so you decided on a portfolio of 60% stocks and 40% bonds based on the very high chance (>95%) that the stock market wouldn’t fall further than 50%. In the case where the stock market fell 50%, you would have lost about $300,000 (half of your $600,000 in stocks) and hopefully remained invested for the recovery.

Now let’s say over the next few years, your assets grew to $1,500,000 with $1,100,000 in stocks. You have gotten used to the idea that your net worth is $1.5m and plan to live off your portfolio based on this amount of retirement assets. Along comes a severe market fall, and you lose over half a million dollars, and you don’t know when the falls will stop. You panic and sell a substantial amount of your assets, thereby missing the recovery and making that loss permanent.

Had you rebalanced along the way by taking some risky growth assets off the table and putting them into defensive assets to ensure you only risked as much as you were comfortable with, you would have lost much less and been more likely to remain invested through the recovery.

Rebalancing growth-to-defensive assets vs rebalancing within growth assets

Rebalancing is most important for your allocation of risky assets (stocks) to defensive assets (bonds or cash) to ensure that when there is a stock market crash, you don’t inadvertently end up with a lot of equities that did well only to see them fall further than you can tolerate seeing your assets fall.

It is far less important to rebalance within your equities (e.g., your Australian vs international equities allocation). However, the same reasoning (risk mitigation) still applies somewhat within equities. If you were Japanese and wanted half Japanese stocks and half the rest of the world and then let it run from 1980-1990 without rebalancing, you would have ended up with a massive overweighting of Japanese stocks due to Japanese stocks having an extraordinary run from the 1970s to 1991. However, Japanese stocks lost an enormous amount of value starting in 1990 and 3 decades later (i.e., now), it still hasn’t recovered. This is different from rebalancing between developed markets (23 countries) and emerging markets (23 countries) due to no single-market risk. In that case, you might not bother rebalancing between those.

Essentially, rebalancing is about risk mitigation. The most important part of that risk mitigation is maintaining your stock to bond allocation. Within your stocks, you need to weigh it up with the tax hit that comes with rebalancing is worth it since selling down appreciated assets requires paying out capital gains tax, meaning that you can no longer earn returns on the delayed tax payment.

Rebalancing in practice

Let’s say you decided on a target asset allocation of

VAS    30%
VGS    50%
VAF    20%

And let’s say you previously had $100,000 and now have $10,000 to add, but by the time you’re ready to top-up your investment, the values have changed (as they usually do).

Previous amounts Now
VAS $30,000 (30%) $24,000 (22%)
VGS $50,000 (50%) $65,000 (59%)
VAF $20,000 (20%) $21,000 (19%)
$100,000 $110,000

You’re now below your target allocation for VAS (30% 🡆 22%) and VAF (20% 🡆 19%) and over your target allocation of VGS (50% 🡆 59%).

To bring it back to our target, we need to rebalance.

To find what our allocation should look like, we add our new parcel of $10,000 to the current value of $110,000, so we have $120,000 and then split that total between our target allocation as in column 3 below.

Then we note the change required for each as in column 4.

Previous amounts Now Target with $10,000 added Change required
VAS $30,000 (30%) $24,000 (22%) $36,000 (30%) +$12,000
VGS $50,000 (50%) $65,000 (59%) $60,000 (50%) -$5,000
VAF $20,000 (20%) $21,000 (19%) $24,000 (20%) +$3,000
$100,000 $110,000 $120,000

In an ideal situation, we would rebalance by selling $5,000 of VGS, add it to the $10,000 and invest $12,000 into VAS and $3,000 into VAF.
But selling down has costs. On top of brokerage costs, we realise capital gains, so it is less tax efficient. Luckily, we don’t need to rebalance into exact proportions every time, so we can just put the whole $10,000 into VAS, and you will have another parcel to bring up the underperformer next time. This is known as “rebalancing with inflows“.

Notice that what is happening here is that you’re buying the cheapest one, so you’re buying low without having to time the market.

I suggest creating your own version of the table above in excel.

When your portfolio gets bigger

As your portfolio grows larger, the changes in your portfolio will begin to dwarf your inflows, and you’ll find yourself getting further and further away from your target. We want to maintain our targeted level of risk. If we decided on 30% in safe assets and it becomes 20%, we have a higher risk than what we decided on.

In this case, you probably want to consider rebalancing by selling down the over performer and buying the underperformer when they get too far out of whack from your target.

Let’s add a zero to all the above figures and see that for a million-dollar portfolio.

Previous amounts Now Target with $10,000 added Change required
VAS $300,000 (30%) $240,000 (22%) $333,000 (30%) +$93,000
VGS $500,000 (50%) $650,000 (59%) $555,000 (50%) -$95,000
VAF $200,000 (20%) $210,000 (19%) $222,000 (20%) +$12,000
$1,000,000 $1,100,000 $1,110,000

Considerations based on when to rebalance by selling

Considerations based on when to rebalance by selling

  1. Selling to rebalance realises capital gains, so there is a cost to doing it too often.
  2. The market tends to run on momentum in the short term, so if you rebalance too often, you’re not waiting long enough for your winners to make their gains and for your losers to become cheap enough.

Tax-efficient rebalancing – superannuation

Updated

Since bonds have the majority of their return as income which misses every type of tax benefit (franking, CGT discount, ability to delay paying tax until you’re retired and on a lower marginal tax rate), you need to be aware of the tax consequences.

When interest rates were higher, it was more tax-efficient to hold your bonds in a low-tax environment like super. There was an additional advantage to this: you could rebalance your total portfolio (including both inside and outside super) from within the portion of your portfolio inside super where your bonds were held.

However, while interest rates are around zero, the returns on high quality bonds are so low that you’re better served using the tax advantages of super for stocks.

I’ve left the previous section viewable in the link below, although I don’t expect that to be useful anytime soon.

Show/hide

Rebalancing rules

The two ways to decide when to rebalance are

  1. By time. Generally, once every year or two has shown to be best, and more frequently than once a year has shown not to help or even make it worse.
  2. By rebalancing bands. The commonly cited rule is the 5/25 rule, where
    • If your target allocation is 20% or less of your portfolio, you would rebalance when it became more than 25% of its proportion from the target. So, if you had an allocation of 10% emerging markets, you would rebalance when it was outside of 7.5% – 12.5%.
    • If your target allocation is over 20% of your portfolio, you would rebalance when the proportion of the total portfolio is more than 5% from the target. So, if you had an allocation of 40% bonds, you would rebalance when it was outside of 35% – 45%.
    • More on the 5/25 rule.
      Rebalancing- The 5/25 Rule – The White Coat Investor
      The Larry Swedroe 5/25 Rule – A Wealth of Common Sense

In the above example (second column), VAF is less than 1% from the target, so no need to rebalance, but VAS and VGS are both more than 5% of the total portfolio from the target, so we would rebalance those – preferably by adjusting the allocation in super to avoid realising gains.

Summary

In accumulation, buy the under-weight one with each new purchase.

In distribution, sell the over-weight one with each new sale.

If that’s not enough, all your accounts should be looked at as one asset allocation. Try to set it up such that you have enough in a low tax environment (super) so that you can rebalance in there to adjust your overall allocation.

If this is still not enough and the market moves so much that this does not stay within your rebalancing bands, and you want to avoid realising gains, you will miss out on the rebalancing bonus, and your risk profile may not meet your needs anymore, so I’d be concerned about letting the tail wag the dog.

Further reading

How to Make a Portfolio Rebalancing Spreadsheet – The White Coat Investor