balance

As part of portfolio construction, advisors can help clients develop a rebalancing strategy that addresses the following:

  • how frequently the portfolio should be monitored;
  • how far an asset allocation should be allowed to deviate from its target before it’s rebalanced; and
  • whether periodic rebalancing should restore

a portfolio to its target or a close approximation.

How frequent and far

Our research emphasizes that rebalancing once or twice a year—and only when a portfolio has wandered from its target by at least 5%—produces absolute return/risk results close to those resulting from more frequent, complicated and time-consuming rebalancing.

We reached this conclusion after conducting a historical analysis from 1926 through 2009 on the performance of several hypothetical portfolios (see “Impact of rebalancing,” below). We compared the risk-and-return characteristics produced relative to a target asset allocation of 60% equities and 40% bonds. The target allocation was rebalanced monthly, regardless of the allocation drift (there was a 0% minimum rebalancing threshold).

IMPACT OF REBALANCING: 1926 THROUGH 2009

Monitoring frequency Monthly Monthly Monthly Monthly Quarterly Quarterly Quarterly Annually Annually Annually Never
Minimum rebalancing threshold 0% 1% 5% 10% 1% 5% 10% 1% 5% 10% None
Average equity allocation 60.1% 60.1% 61.2% 61.6% 60.2% 60.9% 62.6% 60.5% 60.7% 63.0% 84.1%
Costs of rebalancing
Annual turnover 2.7% 2.3% 1.7% 1.3% 2.2% 1.7% 1.5% 1.7% 1.6% 1.4% 0.0%
Number of rebalancing events 1,008 389 58 20 210 50 21 72 28 15 0
Absolute framework
Average annualized return 8.5% 8.5% 8.6% 8.8% 8.7% 8.9% 8.6% 8.6% 8.6% 8.7% 8.1%
Volatility 12.1% 12.1% 12.2% 12.2% 12.2% 12.1% 12.3% 11.9% 11.8% 12.1% 14.4%

Notes: This illustration does not represent the return on any particular investment. It assumes a portfolio of 60% stocks/40% bonds. All returns are in nominal U.S. dollars. There were no new contributions or withdrawals. Dividend payments were reinvested in equities; interest payments were reinvested in bonds. There were no taxes. All statistics were annualized.

Sources: Vanguard’s calculations, using data from Standard & Poor’s, Wilshire, MSCI, Citigroup, and Barclays Capital.

A portfolio rebalanced more often, either because it was monitored more frequently or because it had tighter rebalancing thresholds, tracked the target asset allocation more closely. However, the magnitude of the differences in the average annualized returns and volatility was relatively insignificant.

In addition, a rebalancing strategy that included monthly monitoring and 1% thresholds was more costly to implement (an average of 389 rebalancing events, with annual portfolio turnover of 2.3%) than one that included annual monitoring and 10% rebalancing thresholds (an average of 15 rebalancing events and annual portfolio turnover of 1.4%). In our analysis, the number of rebalancing events and the annual turnover were proxies for costs; actual costs depend on a portfolio’s unique transaction costs and taxes.

Although this analysis implies portfolios rebalanced more frequently track the target asset allocation more closely, it also suggests the cost may limit the optimal number of rebalancing events. Transaction costs and taxes detract from the portfolio’s returns, potentially undermining the risk-control benefits of some rebalancing strategies.

Rebalancing once or twice a year can be useful, and for many investors, there’s little value in making it more complicated.

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