Many commentators advocate an investing strategy based on fixed percentage asset allocations among different types of stocks (large cap, small cap, domestic, foreign), bonds, cash, and possibly other things like commodities, real estate, or precious metals. This brings us to the question of what to do when assets grow beyond or shrink below their target percentages.
The main debate is between rebalancing periodically based on time, such as quarterly, or rebalancing based on percentages, such as when an asset is more than 5% off its target percentage. I don’t particularly like either approach. I prefer a focus on costs.
Suppose that an investor doesn’t have enough savings to qualify for low commissions on ETF purchases, and pays $25 per trade. If this investor doesn’t want to spend more than 1% on the sell and buy commissions, then all trades for rebalancing should be $5000 or more (and trades with new money should be $2500 or more).
This leads to a simple rule: rebalance when the allocation of some asset class is off by at least $5000. This may mean that for small portfolios, allocations can be very far off on a percentage basis. The fact that the portfolio is small means that this is not a major problem. As new contributions come in, the balance will be improved.
With this strategy, larger portfolios will be kept closer to the chosen asset allocation. As portfolios become very large (and qualify for lower commissions), a 1% rule might lead to frequent trading. In this case, the investor can switch to a rule based on a combination of trade size and deviation from the desired allocation.
By this I mean that rebalancing would take place when the allocation to an asset class deviates from the desired percentage by some amount (say 5%) AND the rebalancing would involve trades of at least a minimum size (say $5000).
I’m not a big fan of rebalancing at fixed times because it allow investors to ignore the need to rebalance when the stock market gets “scary”. If stocks drop by large amounts, this is the best time to rebalance. However, most investors ignore their asset allocations until stocks rebound. In this way, they miss the opportunity to profit from the plunge in stocks.
Much of the value of fixed asset allocations comes from buying asset classes when they are down. Failing to do so eliminates most of the upside of the asset allocation strategy.