by Francis M. Kinniry Jr.. Colleen M. Jaconetti and Yan Zilbering

The primary goal of a rebalancing strategy is to minimize risk relative to a target asset allocation, rather than to maximize returns.

It is well documented that a portfolios asset allocation is the major determinant of a portfolios risk-and-return characteristics (assuming a well-diversified portfolio that engages in limited market timing). Yet, over time, asset classes produce different returns, so the portfolios asset allocation will likely drift. Therefore, to recapture the portfolios original risk-and-return characteristics, the portfolio should be rebalanced.

Many investors ask how often, how far and how much to rebalance a portfolio. Similar to the initial selection of a portfolios target asset allocation, the selection of a rebalancing strategy involves a trade-off between risk and return. In theory, investors should choose a rebalancing strategy that weighs their willingness to assume risk against expected returns net of the costs of rebalancingincluding time, taxes and labor.

Using broad U.S. stock and bond market data from 1926 through 2009, we at the Vanguard Investment Strategy Group found that there is no optimal frequency or threshold when selecting a rebalancing strategy. Our analysis demonstrates that the risk-adjusted returns are not meaningfully different if a portfolio is rebalanced monthly, quarterly, or annually; however, the number of rebalancing events and resulting costs increase significantly.

As a result, we conclude that for most broadly diversified stock and bond fund portfolios (assuming reasonable expectations regarding return patterns, average returns and risk), annual or semiannual monitoringwith rebalancing at 5% thresholdsis likely to produce a reasonable balance between risk control and cost minimization for most investors. Annual rebalancing is likely to be preferred when taxes or substantial time/costs are involved.

Return data for this article is based on the following stock and bond benchmarks, as applicable: Stocks are represented by the Standard & Poors 90 index from 1926 through March 3, 1957; the S&P 500 index from March 4, 1957, through 1974; the Wilshire 5000 composite index from January 1, 1975, through April 22, 2005; and the MSCI US Broad Market Index from April 23, 2005, through 2009. Bonds are represented by the S&P High Grade Corporate Index from 1926 through 1968; the Citigroup High Grade Index from 1969 through 1972; the Lehman Long-Term AA Corporate Index from 1973 through 1975; and the Barclays Capital U.S. Aggregate Bond Index from 1976 through 2009.

Theoretical and Practical Considerations

Because asset allocation is the major determinant of a portfolios risk and return, Vanguard believes that the asset allocation decisionwhich takes into account each investors risk tolerance, time horizon, and financial goalsis the most important decision in the portfolio-construction process. It follows, therefore, that its important to periodically rebalance, to diminish a portfolios tendency to drift from its target asset allocation and acquire risk-return characteristics that may be inconsistent with an investors goals and preferences. Note that the goal of portfolio rebalancing is to minimize risk (tracking error) relative to the investors target asset allocation, rather than to maximize returns.

As mentioned, investors often ask how frequently to monitor a portfolio, how far an asset allocation can deviate from its target before it is rebalanced, and whether periodic rebalancing should restore a portfolio to its target or to a close approximation of that target. While each of these decisions has an impact on a portfolios risk-return characteristics, the differences in results among strategies are not very significant. Thus, the choice often becomes one of investor preference.

In addition, costs and emotions are two important practical considerations that can influence rebalancing strategies. Potential rebalancing costswhich can have a direct bearing on the preferred frequencyinclude taxes (capital gains taxes may be due on the sale of appreciated assets in taxable accounts), transaction costs (such as brokerage commissions and mutual fund fees), and the time and labor costs of the investor (or investment manager). Trading restrictions also may limit the frequency of transacting within an account.

The issue: Because asset allocation changes over time as asset classes produce different returns, a portfolio should be rebalanced to recapture its original risk-return characteristics.

The challenge: Investors natural emotional tendencies, along with rebalancing costsincluding time, taxes and laborpose hurdles to implementing a rebalancing strategy.

Conclusion: We found that there is no optimal rebalancing frequency or threshold. For most broadly diversified stock and bond portfolios, annual or semiannual monitoringwith rebalancing at 5% thresholdsis likely to produce a reasonable balance between risk control and cost minimization for most investors.

The natural emotional tendencies of many investors can further make rebalancing a challenge. Since 1926, significant rebalancing opportunities into equities have occurred after strongly negative equity market events on only seven occasions: 1930, 1931, 1937, 1974, 2000, 2002 and 2008. (Assuming a 60% stock/40% bond portfolio and annual rebalancing with a 5% threshold.)

Understandably, at these times, poor investment performance coupled with extreme uncertainty about the future made it seem counterintuitive for investors to consider rebalancing their portfolios by selling their best-performing asset classes and committing more capital to underperforming asset classes. Historically, however, investors who did not rebalance their portfolios by increasing their allocation to equities not only may have missed out on the subsequent equity returns but also did not maintain the asset-class exposures of their target asset allocation.

Investors who are equally loath to rebalance during bull markets can end up with a portfolio that is overweighted to equities, putting the investors portfolios at risk of larger losses compared with their target portfolios.

Trade-Offs in the Rebalancing Decision

As with the selection of an initial target asset allocation, a rebalancing strategy involves a risk-return trade-off. The more risk an investor is willing to assume, the higher the expected return over the long term (known as the risk premium). If a portfolio is never rebalanced, it tends to gradually drift from its target asset allocation as the weight of higher-return, higher-risk assets increases. Compared with the target allocation, the portfolios expected return increases, as does its vulnerability to deviations from the return of the target asset allocation.

To minimize the risk associated with portfolio drift, investors can use several possible triggers to determine when to rebalance. We focus primarily on the following three:

• A time-only strategy, which triggers a rebalancing event based on a set time schedule such as monthly, quarterly, annually, and so on. The choice of frequency largely depends on the investors risk tolerance, the correlation among the portfolios assets, and the costs involved in rebalancing.
• A threshold-only strategy, which ignores the time aspect and triggers a rebalancing event when a portfolio deviates from its target asset allocation by a predetermined minimum percentage, such as 1%, 5%, 10% and so on. The nature of this strategy requires daily monitoring to determine how often to rebalance.
• A time-and-threshold strategy, which combines the time-only and threshold-only strategies. The portfolio is monitored on a set time schedule, but it is rebalanced only if the allocation deviates from the target by the predetermined minimum rebalancing threshold at that time.

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We evaluated the hypothetical results of using each of these three strategies for the period 19262009, assuming a portfolio with a target asset allocation of 60% stocks/40% bonds. For the time-only strategy, we assumed rebalancing monthly, quarterly, annually, and never, with each portfolio rebalanced at the predetermined interval, regardless of the magnitude of variation from the target asset allocation. We found little difference among the results.

For example, monthly rebalancing produced an 8.5% average annualized return with a 12.1% annualized standard deviation, and annual rebalancing produced an 8.6% average annualized return with an 11.9% annualized standard deviation. Both portfolios had an average equity allocation of about 60%. However, the most notable observation comes from comparing the rebalanced portfolio results with the never-rebalanced portfoliowhich drifted to an average equity allocation of more than 84%, with an average annualized return of 9.1% and an average annualized standard deviation of 14.4%.

For the historical, hypothetical analysis of threshold-only rebalancing, we used thresholds of 1%, 5% and 10% deviation from the target asset allocation, and we assumed daily monitoring. (Due to the limited availability of reliable daily data, a time period of 1989 to 2009 was used for threshold-only rebalancing.) The insignificant differences in the results for the risk-and-return characteristics may not warrant the additional costs associated with a 0% threshold (which required more than 5,300 rebalancing events) versus a 10% threshold (which required only four rebalancing events). The primary drawback to the threshold-only strategy is that it requires daily monitoring. Investors can either perform the monitoring themselves or pay an advisor to do it for them (which ultimately lowers the portfolios total return because of the additional cost); the choice depends primarily on investor preference.

The third strategy we evaluated, time-and-threshold, calls for rebalancing the portfolio on a scheduled basis (e.g. monthly, quarterly or annually), but only if the portfolios asset allocation has drifted from its target asset allocation by a predetermined minimum rebalancing threshold, such as 1%, 5% or 10%. If, as of the scheduled rebalancing date, the portfolios deviation from the target asset allocation was less than the predetermined threshold, the portfolio would not be rebalanced. Likewise, if the portfolios asset allocation drifted by the minimum threshold or more at any intermediate time interval, the portfolio would not be rebalanced at that time.

Results of Rebalancing Strategies

Table 1 summarizes the results of several hypothetical portfolios using time-and-threshold rebalancingwith monthly, quarterly and annual monitoring frequencies and 1%, 5% and 10% minimum rebalancing thresholds. We compared the risk-and-return characteristics produced by the various time-and-threshold strategies relative to a target asset allocation of 60% stocks/40% bonds that was rebalanced monthly regardless of the magnitude of the allocation drift (0% minimum rebalancing threshold). The impact of portfolio drift can be seen in the never-rebalanced portfolio in the far right columnwith an average equity allocation of more than 84%.