A Guide to Rebalance Your Portfolio
Take advantage of the up and down of the markets, maximize profits by reducing risks
Over the years you will notice that your portfolio percentage allocation will change drastically if you don’t re-balance it.
The cause is different returns for each class.
As discussed in the portfolio creation strategy article, a portfolio’s asset allocation is the major determinant of a portfolio’s risk-and-return characteristic.
The younger you are, the more risks, you will take by allocating a higher percentage of stock against bonds, and vice-versa as you are getting older.
How often should I rebalance my portfolio?
In my personal experience there is no optimal frequency or threshold when selecting a rebalancing strategy.
I rebalance every six months, but for most people one year is the norm. Rebalancing too often, for example once per month, will result in costs (taxes, fees, time and labor) that required 1,008 events while annual rebalancing with a 10% threshold would require only 15 rebalancing events.
So, I recommend to keep it straightforward and sexy. You will not get richer or poorer by watching your portfolio every day.
As part of the portfolio-rebalancing process, it is important to develop a strategy.
- How often a portfolio should be monitor
- How much is an asset allowed to deviate from its target
As stated early, I rebalance my portfolio every 6 months and don’t let deviate from its target more than 5%.
It is important to recognize that the goal of portfolio rebalancing is to minimize risk (tracking error) relative to a target asset allocation, rather than to maximize returns
Costs incurred in rebalancing the portfolio
I personally rebalance my portfolio by allocating new money to the asset class that has suffer the most in the previous 6 months bringing back the percentage to the original allocation.
Let’s say my initial allocation is worth US$10.000:
- 30% FTSE Japan Index ETF
- 30% S&P 500 Index ETF
- 40% Total Bond Market ETF
After six months the Japan Index have outperformed the US market and Total Bond market.
The portfolio worth is US$11.000, but the allocation structure is changed as follow:
- 35% FTSE Japan Index ETF
- 32% S&P 500 Index ETF
- 33% Total Bond Market ETF
You might get an heart attack at first, thinking someone has access to your account, but don’t worry, this isn’t the case. It is the simple work of the market movements.
By adding US$ 1.200 to the Total Bond Market, I will bring back the portfolio to the original allocation.
The new portfolio will look like this. Total value US$12.200;
- 31.55% FTSE Japan Index ETF
- 28.85% S&P 500 Index ETF
- 39.6% Total Bond Market ETF
I have achieved to rebalance my portfolio only with one transaction for the cost of US$ 15. Numerically speaking, the allocation isn’t perfectly match as the initial allocation but it is within my 5% deviation target.
Every transfer of money inside your ETF portfolio will cost you US$ 15-20 depending on the broker you choose. However, there is some brokerage that offers free transfers, but I think they are only available in the US.
If you need some more example of rebalancing portfolio with more graphic than mine, checkout investopedia.com.
Cost of ETF and Mutual Funds
I prefer ETF to mutual funds because they are cheaper and perform very well, and in most case perform better than active manage funds. ETFs are executed with a computer program, untouched by human hands.
P.S When coming to my money, the less is touched by a human, the better.
Every product has different costs, from a minimum of 0.17% up to few points of percentage. Keep in mind that in the long term, the product’s cost will add up which at first seem minimal, but if compound over the years the amount difference could buy you a new car.
You can learn more about details about the difference between ETF and Mutual Funds so you can make a better decision for your portfolio.
How to rebalance your portfolio
Before getting stuck into rebalancing your portfolio, I would like to stress the importance to do so.
This strategy can boost your returns as well as lower your risks
As said earlier, I rebalance every 6 months because I add up my savings, but there are certain circumstances that make me to take further action.
In average, every year, on any market, we have one or two turbulent swing in the stock markets. It is easy to know this time because every newspaper, radio or TV broadcast the end of the financial world. Media chanels love to inflate the news, and people love to panic in such down turn.
When I heard all these bad news, I get into my brokerage account and switch some money from bonds to stocks.
I have a trance system that the more the market correct, the more I invest in.
- Market correct 10% from the high – first trance of 25% from the Bond Market
- Market correct 20% from the high – second trance of 25% from the Bond Market
- Market correct 25% from the high – third trance of 25% from the Bond Market
- Market correct 30% from the high – fourth trance of 25% from the Bond Market
You will notice the last two trances expect a less degree of market correction. This because it is rare to see the market correct as much as 20%, let alone 30%. This occur during recessions and stress in the financial system.
After the periods of panics, I let the stock market to do its magic, by bouncing back and follow the rising trajectory. Once achieved the correction, I usually rebalance my portfolio to the standard asset allocation in the next portfolio review.
The wider your array of assets, the more independent they are from each other, offering great rebalancing opportunity capitalizing on the swings of the market stock making some extra $$$ over the years.
I recommend my system on rebalancing the portfolio during distress of the financial markets only once you gain enough experience to be able to control your emotions. In the first years of investment, just rebalance your portfolio yearly.
- Rebalance with portfolio cash flows
Rebalancing a portfolio with interest payments, realized capital gains, dividends, or new contributions can help investors both exercise risk control and trim the costs of rebalancing.
Typically, you can accomplish this by redirecting new money to the most under-weighted asset class as part of your scheduled rebalancing event.
- Rebalance to target asset allocation or some intermediate asset allocation
Finally, the decision to rebalance either to the target asset allocation or to some intermediate allocation (near the target allocation) depends primarily on the type of rebalancing costs and spread from the initial asset allocation.
I can conclude that a rebalancing strategy based on annual or semiannual frequencies and reasonable allocation variations of 5% or so, it’s likely to provide sufficient risk control relative to the target asset allocation for most portfolios with broadly diversified stock and bond holdings.