Personal Finance 

The Value of Periodic Rebalancing for Your Portfolio

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This is a guest post by Jon Xu, who is co-founder at FutureAdvisor, a web service that provides unbiased analysis & recommendations to save money on your investment portfolio. Jon is a friend of mine from high school and as someone who has taken a look at FutureAdvisor, I’m excited to see what they have in store for the future. I don’t spend a lot of time on investing but anything that’ll help me reduce fees and optimize my investing is always something I’m interested in reading more about.

We’ve all seen the intuitive value of having a well-diversified portfolio. This is proven to lower risk and allow you to customize exposure to asset classes that match your investment time horizon. Much less glorified is the value of periodically rebalancing assets in a portfolio. This is equally crucial to maintaining a portfolio that matches your risk profile over time. Moreover, it ensures a much smoother ride that matches the risk level of your initial investment.

The concept is simple: as asset values fluctuate, your portfolio diversification changes and you need to divest/invest periodically to keep your diversification on target. Since the mechanics of rebalancing typically call for sell/buys within your portfolio it leads to buying assets that are on the way down and selling those on the way up.

In short: you are buying low and selling high.

When you make re-balancing trades, you effectively lock in market gains and reinvest the proceeds. You also ensure that you will be adequately exposed to asset classes increasing in value. This results in a much smoother ride to the top.

How much smoother of a ride is a periodically rebalanced portfolio? To illustrate, we use the research of David Swensen published in his seminal book Unconventional Success. Here’s an example of two identical portfolios with and without periodic re-balancing:

Note the higher spike and fall of the non re-balanced portfolio. Additionally, if we look at the equity allocation over time, while periodic re-balancing keeps stock/bond split constant, the non re-balanced portfolio allocation goes askew as far as 70/30.

Be sure not to re-balance too often or it will incur transaction costs that eat into your growth. Rebalancing quarterly should be enough to achieve this objective.

{ 5 comments, please add your thoughts now! }

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5 Responses to “The Value of Periodic Rebalancing for Your Portfolio”

  1. sp0rus says:

    Lately when I’ve heard about rebalancing, it’s always been about just keeping the set amounts of each asset class you wanted. No one has talked about the fact that it ends up forcing you to buy low and sell high, and I haven’t really thought about it until now. Thanks for the tip!

  2. I certainly see the wisdom behind this line of thinking. However, I also worry about the negative effect that transaction fees would have on a portfolio of this nature. Would it not be more efficient to simply invest in index funds to mitigate risk and transaction fees?

    • Jon Xu says:

      It’s definitely important to keep an eye on buy/sell transaction fees. In this sense, rebalancing too often can eat into potential growth. Because of market movements, rebalancing quarterly should be sufficient.

      If you’re referring to ongoing cost of owning investments as priced in expense ratio of a fund, you’re absolutely right that index funds are the way to go to implement a well balanced portfolio. Because the much higher ongoing costs of actively managed funds are rarely (if at all) justifiable.

      So using index funds that track specific asset classes, you can build a portfolio that matches your time horizon and as markets move, rebalance quarterly to keep the asset balance the same.

  3. Money Tips says:

    Great tip! Same as Sporus I also never consider “buy low and sell high” scenario.

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