Best Practices for Portfolio Rebalancing

Mutual fund investors know the rationale for portfolio rebalancing. Since asset classes produce different returns, your portfolio’s asset allocation needs to change over time. To get your portfolio’s asset allocation back to its desired level, you need to employ a rebalancing strategy. Although there is no optimal frequency for rebalancing (i.e., monthly, quarterly, annually, etc.), the number of rebalancing events has important cost implications – namely, tax, time and labor.

In general, the more rebalancing events, the higher the cost of maintaining your portfolio. Luckily, that’s where best practices for portfolio rebalancing comes into play.

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Investors have several best practices at their disposal to strategically manage their portfolio rebalancing approaches. In what follows, we will consider four such strategies.

1. Select a rebalancing trigger to instil discipline

We mentioned earlier that there is no one-size-fits-all model for how frequently you should rebalance your portfolio. However, research from Vanguard found that, for diversified stock and bond fund portfolios, annual or semiannual monitoring which rebalances at a 5% threshold is the most effective strategy.

Without the threshold, the number of rebalancing events would be significantly higher and, therefore, costlier. For example, if you rebalance monthly without a threshold, you could be looking at 1,008 rebalancing events. If you did the same thing only with a 10% threshold, you would require only 15 rebalancing events.

In any case, you should set up a fixed schedule of rebalancing regardless of the exact frequency. After all, this is one of the best ways to remove emotions from the investment process.

2. Rebalancing with portfolio cash flows

One of the best ways to keep portfolio management costs under control is to rebalance with existing portfolio cash flows.

The dividends, interest payments and realized capital gains of your portfolio can be used to meet your rebalancing needs. This strategy is most effective for taxable portfolios. Instead of paying taxes on withdrawn earnings, you can simply redirect those funds to underweighted asset classes.

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3. Rebalance to target asset allocation or some intermediate asset allocation

Knowing whether to rebalance to the target allocation or an intermediate allocation can save you lots of money in the long run.

When costs are fixed and independent of the size of the trade, rebalancing to your target allocation is ideal because it eliminates the need for further transactions. However, when trading costs are proportional to the size of the trade, an intermediate approach that rebalances to the closest threshold is optimal.

4. Rebalance within tax-advantaged accounts

It goes without saying that a rebalancing strategy is best executed within a tax-advantaged (i.e., tax-free) account. In practice, this usually means owning a mix of assets in both taxable and tax-free accounts. This set-up gives you a better chance to benefit from any significant adjustments within your tax-advantaged accounts.

Learn about other portfolio management concepts here.

Portfolio rebalancing doesn’t have to be complicated. By following the best practices laid out in this article, you can improve your portfolio’s performance without sacrificing risk control.

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