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rebalancing

What is rebalancing? And why should you make it part of your regular financial exercises? And how often should it be done.

It has been proven time and time again that the by far biggest part of the success of your investments depends on the allocation you choose for your assets, depending of your goals, your possible future income, pensions schemes and above all your risk tolerance.
(Unfortunately no one can predict which assets will be the big winners in the next 10, 20 or 40 years, so it is a greatest importance to diversify properly and as widespread as possible.)

Just assume you have decided on the asset allocation that will accompany you for the next decade or so.
After a while the different asset classes will do exactly what they were intended for: They develop at different speeds and in different directions. And as some assets may make healthy gains, some other ones might actually make a loss in the same time. With these movements the percentages of each asset class within the portfolio changes.
It becomes necessary to bring them back into line, i.e. to rebalance the portfolio, to keep it within the boundaries you set yourself (based on your tolerance of risk.)

To do so is by no means just a cosmetic correction, but a forced approach to make you sell some of the assets that have been doing well recently, and to add to those that have witnessed a slump in the more recent past.

It might seem silly that you have to write it down, but it really should be your declared goal to buy low and sell high.
Human nature is not very kind to those that forget this statement.
We are all inclined to follow the herd and therefore buy when everyone is buying i.e. the prices are rising and sell when everybody is moaning about the markets.

Back to rebalancing: consider a very basic portfolio, with just two assets in it, stocks and bonds, 50% each.

Any given year these two asset classes will behave quite differently. After a year or two the previously chosen asset allocation is just not the same anymore, anything but 50/50 . By selling** some of the better performing assets in order to buy of the poorer performing ones you are forced to sell high and buy low, and you keep your risks under control.

Let’s illustrate the above said:

Take the two mentioned assets, of which you have purchased CHF 10’000 each on the first of January. By the end of the year the stocks, having had a very good year, have gained 18%, whilst the bonds have given you a 2% return. All over sudden your allocation starts looking slightly lopsided, with stocks making up 53.6% of your portfolio, and your bonds only 46.4% . Should you let this run it’s course you would end up with a very different asset allocation than planned within a few short years.
Five years later, and you have witnessed a strong bull market for stocks, returning 12% annually, against only 1.5% for the bonds. You end up with a stock allocation of 62% against only 38% bonds. Not the same risk anymore.
Should you decide to leave things as they are the next sharp fall in stock prices will cause you sleepless nights, something investments should never do.

As to the frequency of the rebalancing: take once every year, or every 400 days, or every 17 months. So far we have not found an indication of any real difference due to a couple of month either way. Anywhere between once a year and every two years should do.

There is one caveat though, always keep an weary eye on the cost involved in buying and selling funds, ETF’s or what ever instruments you are using. If the actual transaction cost eat more than 1% of the amounts that are changing from one asset class into another have another think.

There is a very nice spreadsheet on the timing of rebalancing, even allowing for costs.:

** For those that are still adding to their portfolio, simply buying the asset class that is furthest of the track should do the trick, sparing you the cost of selling some of the assets in order to buy more of the weaker ones. Should you enjoy fiddling with Excel sheets you could still add a barrier which could kick off a rebalancing once an asset class gets to far out of bounds, maybe overrunning the allocated percentage by more than 10%