The idea behind rebalancing a portfolio is to maintain your intended asset allocation percentages. A side benefit is that rebalancing involves selling one asset when its price is high and buying another when its price is low. I’ll show that this process can actually lose money if you’re not careful.
It is tempting to rebalance whenever assets differ from their target amounts by some fixed dollar amount. However, this doesn't always work well. Portfolio size matters. Larger portfolios should wait for larger deviations from target levels when the deviations are measured in dollar amounts.
I’ll use a very simple example to illustrate the problem. In a real portfolio, there are many factors that mask what is going on making it difficult to judge whether rebalancing is profitable or not.
A Fictitious Portfolio
Suppose that Jim’s portfolio consists of just two ETFs: BND and STK. Jim’s intended asset allocation is 50/50. Initially Jim has 1000 shares of each and they trade at $20 per share for a total portfolio value of $40,000.
A few months later, BND is down to $18 and STK is up to $22. Both assets are $2000 away from their target amounts in Jim’s portfolio. So, Jim decides to rebalance. He sells 100 shares of STK and buys 100 shares of BND. Before costs, this leaves an extra $400 in his account.
After another few months, BND and STK have both returned to $20. Jim decides to rebalance again by selling 100 shares of BND and buying 100 shares of STK. Jim’s portfolio is now back to exactly what it would have been if he had never done any rebalancing, except that he has an extra $400 (less costs).
Suppose that each trade costs Jim a $10 commission and the bid-ask spread is 4 cents. This means that Jim pays an extra 2 cents per share on each buy order and receives 2 cents less per share than the going price on each sell order. In total, Jim made 4 trades and traded 400 shares. He paid $40 in commissions and $8 in spread costs. His profit from rebalancing twice is $352.
A Larger Portfolio
Suppose that Sue’s portfolio is very similar to Jim’s except that hers is 20 times larger. She starts with 20,000 shares of each of BND and STK at $20 per share each. Sue plans to rebalance her portfolio whenever BND and STK differ from their target levels by $2000 or more, just as Jim did. The big difference here is that it will take a much smaller move in ETF prices to trigger Sue to rebalance.
After a couple of days, BND is down to $19.90 and STK is up to $20.10. Both assets differ from their target amounts in Sue’s portfolio by $2000 and Sue rebalances by selling 100 shares of STK and buying 100 shares of BND. The big difference from Jim’s case is that this leaves only an extra $20 (less costs) in Sue's account.
After another couple of days, BND and STK return to $20 triggering Sue to sell 100 shares of BND and buy 100 shares of STK. Sue’s costs will be the same as Jim’s: $48. But her profit before costs is only $20. She actually lost $28 doing this rebalancing. Sue would have been better off to have done nothing.
Even though both Sue and Jim traded the same number of shares, Sue lost money and Jim made money. The lesson is that the threshold for rebalancing can’t be just some fixed dollar amount of deviation from target amounts.
It’s important to keep in mind that while this problem is fairly easy to see in this example, it is difficult to see it in a real portfolio. Equity prices don’t behave simply the way they did in this example. They move around randomly and rarely sit at nice round figures.
However, losses from rebalancing are still a real possibility. Hyper-active rebalancing can make you lose money whether you realize it or not. This is particularly true when rebalancing between assets denominated in different currencies. Currency conversion charges effectively raise spread costs by roughly a factor of 10 to 100.
One of the best ways to rebalance is to put new money into whichever asset class is below target. When percentages get far enough away from target that this doesn’t work and you plan to rebalance by buying and selling, make sure that trading costs don’t eat up your gains.