Rebalancing is a core discipline of good portfolio management. It is not only a core discipline but also adds to your long-term expected return and has delivered in 2020!

Portfolio Allocation Defined

Your portfolio allocation is simply how much of your portfolio is invested in various types of investments measured in percents. Below is a sample Super-Diversified Portfolio allocation. In this portfolio, for example, the goal is to have 6.0% in U.S. Large-Cap stocks.

This accompanying table shows the TARGET, or desired, allocations. These target allocations are different for various investors depending on their desired risk profile.

What is rebalancing?

As discussed above, a portfolio has TARGET, or desired, allocations based on an investor’s risk profile. As investments go up and down over time, the CURRENT allocations are no longer equal to the TARGET allocations. Rebalancing is the process of bringing a portfolio’s CURRENT allocations back to the desired TARGET allocations.

Let’s use the above sample Super-Diversified Portfolio to illustrate how rebalancing works. The TARGET allocations for U.S. stocks and International stocks is 18% and 16% respectively and Fixed Income is 15%. Let’s now assume that stock prices decline and bond prices go up as generally happened during the first quarter. The result is that the allocation to stocks shrank, due to falling prices, while the allocation to bonds increased due to rising prices as illustrated in the below table.

Bringing the portfolio’s CURRENT allocations back to the TARGET allocations is the process of rebalancing. In this example, a portion of the bonds are sold to reduce the current allocation and stocks are bought to raise their allocations. When this is complete the portfolio will once again be allocated according to the target allocations.

Why rebalance?

The primary reason for rebalancing is to maintain a consistent risk profile in your portfolio. When a portfolio is no longer allocated similar to its target allocations, the risk profile of the portfolio has changed. In the above example, the portfolio had one-third more bonds than desired and less stocks resulting in a risk profile that is lower than desired.

Added returns are the second reason for rebalancing. As I mentioned above and explain more below, our average Super-Diversified portfolio achieved an EXTRA +1.1% return in just 36 days due to the rebalancing we did in March. This is an extreme example of the added return to expect in such a short period of time. Based on our research and others, portfolio returns can be improved by roughly 0.5% to 1.0% annually on a risk-adjusted basis depending on the rebalancing strategy and time period considered.

The Emotional Challenge and More

The process of rebalancing often conflicts with the typical investor’s emotions. Consider that rebalancing is to sell some of your investments that have recently gone up and buy more of your investments that have recently gone down. This tends to go against every emotion in your body! As a result, most investors will not do it.

Beyond the emotional, most investors simply do not have the discipline to rebalance. To rebalance your own portfolio, you must set aside time, evaluate your portfolio, do some math to figure out what needs to be done, then request some trades. It’s simply more than most investors will do.

Patton’s Rebalancing Process

There are a variety of rebalancing strategies differing primarily by 1.) the frequency of doing so (monthly, quarterly, annually, etc.) and 2.) what other things must happen to trigger an event.

Each asset class allocation in our clients’ Super-Diversified portfolios has a tolerance indicating how different the current allocation must be to the target allocation to trigger a rebalance. This tolerance, or difference, is generally 10%. For example, if the target allocation to an asset class is 15%, the tolerance would be 1.5% (or 10% of 15%). Therefore, we will rebalance when the current allocation falls below 13.5% (15.0% target - 1.5% tolerance) or rises above 16.5% (15.0% target +1.5% tolerance).

We compare the current allocations to the target allocations approximately every 4-6 weeks. At that time, if an asset class’s current allocation is outside of the tolerance set, the portfolio is rebalanced. When we compare these allocations they often are NOT outside the desired tolerance and, therefore, do not get rebalanced. Any given client’s portfolio will typically be rebalanced 2-3 times per year generally depending on market volatility.

How it worked during the 36 days in 2020

We rebalanced our client portfolios on March 18^th. This was deep into the stock market’s decline from its highs. Similar to the example above, stocks had gone down while bonds had gone up resulting in client portfolios having CURRENT allocations for stocks that were below the TARGETS and bond allocations that were above. This rebalancing therefore resulted in selling bonds, to reduce the over-allocation, and buying stocks to increase the allocation. An example of just one asset class, U.S. Small-Cap Stocks, is illustrated in the below table.

The above table illustrates the impact on a $1 million portfolio to keep the math relatively simply. The performance impact on our clients’ portfolios is not impacted by their size.

As the table shows, on March 18^th our average client portfolio allocation to U.S. Small-Cap Stocks had fallen to just 4.4% as compared to the target of 6.0%. During this rebalancing, we purchased $16,003 of Small U.S. Stocks for a typical $1 million portfolio bringing the current allocation back to 6.0%.

During the next 36 trading days after we rebalanced, up to the next time we rebalanced on May 8^th, Small U.S. Stocks rose by 32.4%. The additional $16,003 of Small U.S. Stocks purchased during the March 18^th rebalancing gained $5,185. For a $1 million portfolio, this is an EXTRA gain of +0.5%...a gain that would NOT have occurred had it not been for the rebalancing.

The above represents the impact of just one asset class in the portfolio. The rebalancing of all the asset classes individually was not positive as the below table shows. For example, we sold Mid-Term U.S. Government Bonds, the allocation had grown above the desired tolerance, and these bonds subsequently went up in price. Some gains were missed because of this but fortunately these missed opportunities were far outweighed by the gains in those asset classes that were added to during the rebalancing.

As the above table shows, the aggregate impact of rebalancing on a $1 million portfolio was an EXTRA gain of $10,868 or +1.1%. Again, a $1 million portfolio is only shown for illustration purposes. Regardless of our client’s portfolio value, our average client benefited with an EXTRA +1.1% return due to the rebalancing done on March 18^th.

As already noted, the primary purpose of rebalancing is to maintain a consistent risk profile in the portfolio. The added return is secondary but very important and meaningful. The excess return during this relatively short period of time is extreme and also very much welcomed! Such excess returns due to rebalancing cannot be expected regularly but improved returns of 0.5% to 1.0% annually are possible and will contribute to achieving great long-term returns.

Taxes and Trading Costs

Excluding tax-deferred accounts such as IRAs, the buying and selling that takes place when rebalancing is a taxable event generating realized gains and losses. Once an account has been investment for more than 12 months though the majority, if not all, of the tax consequences are at long-term rates.

The following is an analysis of an actual client’s Super-Diversified Portfolio over a 4-year period. It is generally representative of a typical client’s portfolio although every client’s tax circumstances could be different.

In the above example, the portfolio value started 2016 with $1 million. Our systems, following the process described above, triggered a rebalance in his portfolio three times (“# of Events”) during 2016 totaling 3,867 shares of securities and a gross total trade value of $211,522. These trades generated no Short-Term gains and $4,355 of taxable Long-Term gains.

The $4,355 Long-Term gain is NOT the amount of tax that has to be paid but instead the amount on which tax has to be paid. Assuming a long-term tax rate of 25%, as an example, the taxes payable would be $1,089. During this 4-year period, the average tax payable was $2,109 or less than 0.2% of the average account balance. The benefits of rebalancing clearly outweigh the negative impact of taxes. Furthermore, the taxes paid now will reduce the amount of taxes paid later further reducing the tax impact.

In addition to tax consequences, trading costs must also be considered. In today’s environment, trading costs are generally very low and an inconsequential cost. The vast majority of our clients are paying just ½ cent per share in commissions. In the above example, transaction costs averaged $12.29 per year…an immaterial amount on a $1 million portfolio.

Research and experience shows that the benefits of rebalancing are more than outweighed by the tax and trading costs.

Conclusion

Rebalancing is a well-researched and proven process to improve long-term portfolio returns. It is an essential discipline to the overall investment process and a successful investment strategy. This is done for all of our clients with Super-Diversified portfolios.

Disclosures

Approximately 94.4% of capital invested in asset classes that were rebalanced are included in this analysis. Excluded asset classes are in only a very limited number of client portfolios. Each client’s impact of the March 18^th rebalancing was slightly different but averaged approximately +1.1%.
Research on Rebalancing:
“Getting back on track: A guide to smart rebalancing” by Vanguard
“Rebalancing and Returns” by Marlena I. Lee