With stock markets skidding down and bond yields dropping like a stone, many investors will likely find that the allocation to stocks in their portfolio is now below target and the allocation to bonds is above their target. Disciplined investors should regularly rebalance their portfolios to bring the allocations back to target but are likely wondering how they should go about it. Should they rebalance monthly or annually? Should they rebalance only when the current allocations are above or below some threshold? Or should they simply rebalance by directing new savings and portfolio income to the lagging asset class?
The authors of a Vanguard paper titled Best Practices for Portfolio Rebalancing attempt to answer these questions by analyzing the returns and volatility of a 60% stock-40% bond portfolio under different rebalancing strategies. The rebalancing strategies considered were based on time (monthly, for example), threshold or a combination of the two. Threshold rebalancing means a portfolio would be rebalanced only when the asset allocation has drifted from the target by a predetermined threshold. For example, a portfolio that has 20% in bonds and a 5% rebalancing threshold will be rebalanced when the allocation to bonds exceeds 25% or drops below 15%.
Perhaps unsurprisingly, the authors find that portfolios that were never rebalanced posted higher returns (with a higher SD) than portfolios that were rebalanced in some form. But it is surprising that the portfolios that were rebalanced based on time (monthly, quarterly or annually), threshold (0%, 1%, 5% or 10%) or a combination of the two produced similar returns with comparable volatility. The difference, of course, is that some rebalancing strategies resulted in a much higher portfolio turnover than others. For example, monthly rebalancing resulted in 1,008 events compared to just 58 for monthly rebalancing with a 5% threshold.
Real world investors care about such things as stock commissions, bid-ask spreads and taxes and will, therefore, prefer a strategy with low turnover. The rebalancing strategy with the lowest turnover was one in which portfolio income (such as dividends and interest payments) was invested in the underweight asset class. It may not be a practical strategy for portfolios with little or no inflows in an era when dividend yields and bond yields are so low but it should still work for investors who are regularly investing new savings.
