When and how to rebalance

 

There are risks in letting your asset allocation drift too far from your target—including ending up with more risk in your portfolio than you signed up for. At the same time, there are taxes and trading costs associated with rebalancing. In a recent paper, Vanguard investment strategists analyzed approaches to portfolio rebalancing and how it can be optimized.

A comparison of common rebalancing methods

The Vanguard team examined three methods often employed by investors, advisors, and asset managers for rebalancing portfolios:

• Calendar-based rebalancing designates a frequency for resetting the portfolio back to the target asset allocation. More frequent rebalancing results in lower tracking error and higher transaction costs, absent cash flows to aid in rebalancing.
• Threshold-based rebalancing is triggered when the portfolio breaches a specific percentage of deviation from the target allocation. One major drawback of threshold-based rebalancing: It requires that the portfolio be monitored daily and is thus not practical for investors who manage their own portfolios. The smaller the threshold, the lower the tracking error and the higher the transaction cost.
• Calendar- and threshold-based rebalancing combines both rebalancing approaches. Based on a calendar frequency, the portfolio is rebalanced if it has strayed by more than a specific percentage from the target allocation.

Which method is optimal?

Our strategists employed a framework for determining an ideal risk-return and cost-efficient rebalancing strategy. You can learn more about the methodology in the research paper. It requires forecasting a distribution of asset returns (an entire range of returns rather than a single-point forecast) and transaction costs, which are critical in assessing the impact of rebalancing on portfolio wealth after transaction costs are taken into account.

For investors who don’t participate in tax-loss harvesting or who are not concerned with maintaining tight tracking to a multiasset benchmark portfolio, rebalancing a portfolio on an annual basis was the best method in terms of the risk-return trade-offs. It is optimal largely because it allows investors to harvest the equity risk premium while also generating lower transaction costs than more frequent rebalancing.

 

Notes: Results are based on simulations from the forecasting framework and maximization of post-transaction-cost wealth for various portfolios and rebalancing strategies shown above. The CFE (certainty fee equivalent) is the benefit of selecting the optimal rebalancing strategy relative to another rebalancing method or, conversely, the fee an investor would be willing to pay relative to another rebalancing method. “Bps” equals basis points; a basis point is one-hundredth of a percentage point. U.S. bonds are represented by the Bloomberg U.S. Aggregate Bond Index, non-U.S. bonds by the Bloomberg Global Aggregate ex-U.S. Index, U.S. equities by the MSCI US Broad Market Index, and non-U.S. equities by the MSCI All Country World Index ex USA. Data are as of June 2022.

Source: Vanguard.

 

Do exceptional markets merit exceptional rebalancing?

While stock market declines like the one we’ve experienced this year may tempt investors to rebalance more frequently, our research indicates that less-frequent rebalancing is efficient even during periods of market turmoil. Transaction costs tend to rise during volatile environments, which makes rebalancing expensive. Moreover, an investor may rebalance in one direction and then have to reverse the transaction because the market whipsawed the opposite way, which can happen during periods of turmoil.

The bottom line

Our research shows that optimal rebalancing methods are neither too frequent, such as monthly or quarterly calendar-based methods, nor too infrequent, such as rebalancing only every two years. For many investors, implementing an annual rebalancing is optimal.

 

 

Notes:

All investing is subject to risk, including the possible loss of the money you invest. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.

Investments in bonds are subject to interest rate, credit, and inflation risk.

Publication date: October 2022  

The information contained in this material may be subject to change without notice and may not represent the views and/or opinions of Vanguard Investments Canada Inc.

Certain statements contained in this material may be considered "forward-looking information" which may be material, involve risks, uncertainties or other assumptions and there is no guarantee that actual results will not differ significantly from those expressed in or implied by these statements. Factors include, but are not limited to, general global financial market conditions, interest and foreign exchange rates, economic and political factors, competition, legal or regulatory changes and catastrophic events. Any predictions, projections, estimates or forecasts should be construed as general investment or market information and no representation is being made that any investor will, or is likely to, achieve returns similar to those mentioned herein.

While the information contained in this material has been compiled from proprietary and non-proprietary sources believed to be reliable, no representation or warranty, express or implied, is made by The Vanguard Group, Inc., its subsidiaries or affiliates, or any other person (collectively, "The Vanguard Group") as to its accuracy, completeness, timeliness or reliability. The Vanguard Group takes no responsibility for any errors and omissions contained herein and accepts no liability whatsoever for any loss arising from any use of, or reliance on, this material.

This material is not a recommendation, offer or solicitation to buy or sell any security, including any security of any investment fund or any other financial instrument. The information contained in this material is not investment advice and is not tailored to the needs or circumstances of any investor, nor does the information constitute business, financial, tax, legal, regulatory, accounting or any other advice.

The information contained in this material may not be specific to the context of the Canadian capital markets and may contain data and analysis specific to non-Canadian markets and products.

The information contained in this material is for informational purposes only and should not be used as the basis of any investment recommendation. Investors should consult a financial, tax and/or other professional advisor for information applicable to their specific situation.

In this material, references to "Vanguard" are provided for convenience only and may refer to, where applicable, only The Vanguard Group, Inc., and/or may include its subsidiaries or affiliates, including Vanguard Investments Canada Inc.