Are you one to rebalance your portfolio? Do you believe that it will make a big difference if you do not do it? Well, over a 20 year period from 1994 until 2014 if you took one of the three options we will look at in this blog I will explain the outcomes. The purpose of rebalancing is to keep your portfolio at the desired mixture of assets that you have identified in your financial plan. But as I will show you at the end of this blog the difference may not be as big as you think.
The main question people must ask themselves when they rebalance is when and how to do it. The most popular methods are the calendar and threshold methods. Both are effective, and both have their own merits. But one thing that a person must consider is the costs associated with any rebalancing of their portfolio. Regardless of the method you chose you always need to keep costs in mind to maximize your potential returns.
As I have said in previous blogs I do believe that rebalancing does have a place in someone’s portfolio and if done properly can increase your returns. The reason behind rebalancing is to sell assets that have gone out of your desired percentage while they are high and buy additional portions that are not experiencing gains at that moment. In most years and most cases, this involves selling equities and buying bonds as historically equities have outpaced bonds in performance.
Now if you rebalance based on a time period such as three, six, or twelve months regardless of how out of balance the portfolio is you may end up costing yourself more in commissions than you will gain in portfolio performance. There is no reason to keep perfect portfolio balance if you will only move a few hundred dollars, and the cost in commissions is said $50. That just simply does not make good financial sense.
Now if you rebalance using the threshold method and set your rebalance points at say a 5% difference the costs may be worth your while. By rebalancing at the 5% threshold, you ensure you are not rebalancing too often but often enough to take advantage of the highs and lows of the markets. Some people will suggest to rebalance as low as 3% or as high as 10%, but I personally believe that between 5% and 7% is a good target range. Again, this ensures you can take advantages of market ups and downs.
According to an article, I recently read there were three scenarios that were taken into account. In all three there was a beginning balance of $100,000 in a 70% equity and 30% bond split. From 1994 to 2014 these accounts were monitored for performance with one not being rebalanced at all, one on the calendar method and the third on the threshold method at 5% deviation from the desired target range. In the portfolio that was not rebalanced the equities ended at 83% and the bonds at 17% with an overall balance of $557,000 or a 9% return. The calendar method produced a final account total of $579,000 for a 9.2% return with 19 points of rebalancing, one for each calendar year. With the threshold method, the portfolio was rebalanced ten times over the 20 year period and had an ending value of $580,000 for the same 9.2% return as the calendar method.
Now 0.02 is not a huge difference and as the study showed only netted a $1,000 gain from the two portfolios that rebalanced. Now the 0.02% gain between the two portfolios that rebalanced and the one that did not was significant at almost $23,000 in additional gains. This goes to show that the power of compounding interest is significant even with small percentage gains in portfolios performance. Also, by using the threshold method you save almost half the price of the commissions involved with the calendar method.
I still believe that rebalancing holds a spot in anyone’s financial plan and should be done but mainly on the threshold method as it saves on commissions and does take advantage of market highs and lows. For more information or if you have any questions feel free to contact me.
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