Rebalancing an investment portfolio is one of the vague areas of finance and investments where academia presents a number of theories but carrying out those theories in practice isn’t quite as simple. As with many confusing areas of investing and personal finance, this is a topic that has been discussed and researched by countless academics, financial firms, and professional investment managers. Yet different conclusions are presented and varied arguments are made supporting or rebuffing different rebalancing strategies. Any of these groups would likely agree that following a predetermined investment strategy is important, even though they might not agree on what that strategy should be.

The Case for Rebalancing

The argument for rebalancing is straightforward and simple, but the optimal rebalancing frequency and strategy is highly debated. In theory, it makes perfect sense to develop an investment objective to determine how much money should be allocated or devoted to specific asset classes like stocks, bonds, and cash. Since each of these asset classes has different risk and return characteristics, spreading money across them can help reduce risk in an investment portfolio. Under typical market conditions, bonds may fall or remain steady as stocks increase. On the other hand, bonds may increase in value when stocks fall.

Consider an investment portfolio made up of 50% bonds and 50% stocks. If stocks increase in value faster than the bonds, the portfolio could quickly become 40% bonds and 60% stocks, making it a riskier portfolio than what you originally intended. Selling an appropriate amount of the stock to buy additional bonds will rebalance the portfolio to the original intended 50%/50% mix. Conversely, if the stocks fall more than the bonds, this would require the investor to sell bonds and buy more stock. Following a set rebalancing strategy like this also allows investors to avoid some major pitfalls associated with investment decision making. This is the reason rebalancing a portfolio makes sense.

Removing Emotion From the Investing Equation

Behavioral finance theories tell us, and have proven to some extent, that human nature leads investors to buy high and sell low. This is obviously the opposite of sound investing principles. Nevertheless, investors tend to follow a “herd mentality” and buy stocks when the market is already at high levels. Then they grow concerned as the market falls and ultimately sell the stocks when they are scared of losing more money. The nature of rebalancing a portfolio itself can lead to better control in investing and remove this behavioral decision making process from the equation altogether, leading investors to buy low and sell high.

Reducing Risk and Improving Performance

In the previous example of a 50% bond/50% stock portfolio with a rebalancing strategy in place, a significant rise in stock prices would require us to sell stocks when they go up and reallocate the proceeds from those stock sales into bonds. In this case, the investor would have been taking stock gains along the way and buying more bonds, so when the market falls, the investor will theoretically be in a better position to withstand that drop. Since bonds have historically risen when stocks fall, the investor would be selling bonds to buy stocks in order to rebalance one again to the original intended mix of 50%bonds/50%stocks. In essence, a rebalancing program by its very nature requires investors to follow a disciplined investment approach that can lead to better performance. Most people would agree with this logic.

Optimal Rebalancing Frequency

The question becomes, how often is it necessary to rebalance, and what is the optimal rebalancing frequency? This is where the many conflicting opinions and research reports begin, but a good place to start is to review the basics.

Rebalancing a portfolio will usually incur transaction costs associated with selling and buying stocks, bonds, or other investments. There may be a transaction cost to sell and an additional transaction cost to buy. Frequent transactions can lead to costs that significantly reduce overall investment returns over a long period of time. Not rebalancing often enough, however, may cause investors to miss optimal opportunities to reduce portfolio risk and take advantage of short term gains in a particular asset class.

A Vanguard Research report on optimal rebalancing periods analyzed various portfolio rebalancing frequencies and determined that there was no frequency that lead to an optimal risk/return balance. However, the report did reinforce the fact that more frequent rebalances leads to increased transaction costs, significantly impacting long term performance.

Two Ways to Rebalance

There are two ways to address a rebalancing strategy. The first approach is to rebalance at predetermined monthly, quarterly, semi-annual, or annual intervals. The second approach is to rebalance each time an asset class increases to a set threshold. So if the stock allocation of a 50% bond/50% stock portfolio reaches 55% or 60%, this would trigger a rebalance back to the intended 50/50 mix.

Optimal Strategies

The most optimal rebalancing strategy is likely a combination of the timing rebalance and threshold rebalance. Numerous studies have estimated that the average historical bear market lasted 13-15 months and the average bull market lasted approximately 3.5 years. Given these historical time ranges, a semi-annual rebalancing strategy coupled with a 10% threshold rebalance may provide an optimal rebalancing mix. With this rebalancing approach, the portfolio would be rebalanced twice in the average bear market and 6-7 times across the average bull market with possible rebalances in between due to the 10% rebalance trigger. This would allow the portfolio to maintain the original intended risk return profile without accumulating unnecessary transaction costs.