For investors who maintain constant portfolio allocations to different asset classes, such as stocks and bonds, there is a debate about when to rebalance. Most advice is to rebalance periodically, such as quarterly or yearly. Others suggest a threshold approach where rebalancing is based on when the allocation gets sufficiently far from the target allocation. I am in this latter camp.
The idea behind periodic rebalancing is to have a defined time to look at your portfolio, sell some of the assets that have grown beyond their target percentage, and buy the ones that are below. With the threshold approach, we wait for assets to get a certain percentage away from the target percentage and then rebalance. This could take just hours or it could take years.
Here is a simple example. Sally has her retirement savings equally split between a stock ETF and a bond ETF. (In my case it would be two different stock ETFs because I prefer not to own bonds for the long term.) Over time, the ETFs will rise and fall in value and throw her 50/50 allocation out of whack. Sally could ignore her portfolio until the first trading day each quarter to rebalance. If stocks are up, she would sell some stock ETF shares and buy some bond ETF shares to restore balance.
Another approach would be to set a window of say 45% to 55% and if the allocation gets outside of these thresholds, then rebalance. With either approach there are more choices to make. With periodic rebalancing you have to decide how often, and with threshold rebalancing you have to decide how wide to make the window.
I prefer to rebalance based on thresholds because the profitability of rebalancing depends mainly on how far out of balance the allocation becomes. A criticism of this approach is that it can lead to too much trading during volatile periods, but I'm not concerned with this if the trades themselves are profitable.
Profitability of rebalancing is best illustrated with an example. I'll cook the numbers a little so that we don't have to deal with fractions. Suppose that the stock and bond ETFs are currently trading at $55 each, and Sally owns 990 units of each. Let's assume that over a period of time the bond ETF stays flat at $55, but the stock ETF drops to $45 and then returns to $55. With a 45/55 threshold, this would trigger Sally to do some rebalancing:
Stocks: 990 at $55
Bonds: 990 at $55
Stocks: 990 at $45
Bonds: 990 at $55
Sally rebalances by selling 90 bond ETF shares ($4950) and buying 110 stock ETF shares with the proceeds. (We'll look at trading costs later.)
Stocks: 1100 at $45
Bonds: 900 at $55
Stocks: 1100 at $55
Bonds: 900 at $55
Stocks: 1000 at $55
Bonds: 1000 at $55
If Sally had done nothing over this period of time, her return would have been exactly zero. By rebalancing, she ended up with an extra 10 shares of each ETF, a gain of $1100 less costs. She made 4 trades and traded a total of 400 shares. Assuming commissions of $10 per trade and losses of one cent per share in bid-ask spreads, Sally's costs are $44 for a total profit of $1056.
Other things that can affect the profitability of rebalancing are capital gains taxes for non-registered accounts and currency conversions if the ETFs are traded in different currencies.
It doesn't matter how long it takes for stocks to drop and rise back up again; these trades profit over the "do nothing" strategy whether they take place over hours or years. This is the reason why I prefer threshold-based rebalancing rather than doing it periodically.
To set thresholds wide enough to create profits after trading costs, it's important to take into account all costs. Capital gains taxes and currency conversion costs can make a big difference. Another thing to consider in very volatile times is that bid-ask spreads can widen dramatically and significant price changes can take place between selling the overweight holding and buying the underweight holding.
In practical terms, by choosing appropriate thresholds, trading will be infrequent. However, I prefer to be ready to pounce if volatility takes my allocation outside the thresholds rather than to miss out by waiting until the next planned rebalance day.
An advantage of periodic rebalancing is that you can ignore your portfolio for months at a time. A possible compromise is to check thresholds perhaps weekly. If price changes don’t last at least a week, conditions may be too volatile to trade at predictable prices. Personally, I tend to check roughly 2 or 3 times per week using rules coded in a spreadsheet.