The idea of rebalancing a portfolio to maintain target asset allocation percentages is simple in theory, but tricky in practice. It is not obvious how far asset class percentages should be away from their targets before it makes sense to rebalance. I have developed a scheme that I use myself that I fully automated in a spreadsheet. Instead of obsessing over my portfolio’s returns, I can just check whether one cell is red to indicate that I need to rebalance.
Investors should use any new savings or withdrawals they make as opportunities to rebalance by buying low asset classes or selling high ones. However, as a portfolio grows, rebalancing with new savings and withdrawals is unlikely to be enough to maintain balance when asset classes have big swings.
Common advice is to rebalance a portfolio on a fixed schedule, such as yearly. This has the advantage of allowing investors to avoid obsessing over their portfolios all the time, but has the disadvantage of missing potentially profitable opportunities to rebalance. Computing thresholds automatically in a spreadsheet permits me to check one cell in the spreadsheet for a glowing red “rebalance” once or twice per week without having to look at anything else. This gives me the advantages of threshold rebalancing without the disadvantages.
When choosing rebalancing thresholds, most experts advise investors to either use percentage thresholds or dollar amount thresholds. For example, you might rebalance whenever you’re off target by more than 5%, or alternatively by more than $2000. However, these approaches don’t work for all portfolio sizes. Percentage thresholds lead to pointless rebalancing in small portfolio, and dollar amount thresholds lead to hourly trading in very large portfolios. We need something between these two approaches.
When asset class A rises relative to asset class B, and then A drops back down again to the original level relative to B, rebalancing produces a profit over just holding. I compute rebalancing thresholds based on the idea that the expected profit from rebalancing should be 20 times the ETF trading costs.
All the mathematical details of how I compute rebalancing thresholds are in a 6-page paper “Portfolio Rebalancing Strategy”. I’ll just give the results here.
The spreadsheet starts by computing the following quantities for each ETF:
m – Current portfolio total value times the target allocation percentage. This is the target dollar amount for this ETF.
s – Bid-ask spread divided by the ETF share price.
Other parameters are
c – Trading commission.
f – Desired ratio of trading costs to expected profits. I use 0.05 so that the expected profits from rebalancing are 20 times the trading costs.
The dollar amount threshold for rebalancing then works out to the following formula which may seem a little intimidating, but it only has to go into a spreadsheet once.
t = [m/(2f)] * [s + sqrt(s*s + 8*f*c/m)].
So, it makes sense to rebalance an asset class if its dollar level is below m-t or above m+t. As long as there are at least two asset classes far enough out of balance (with at least one too high and at least one too low), it makes sense to rebalance.
When holding some ETFs denominated in Canadian dollars and others in U.S. dollars, rebalancing may involve currency conversion, which can be expensive. To deal with this, I actually think of the Canadian and U.S. portfolios as separate portfolios with their own asset allocations. Then I think of the sub-portfolios as asset classes in a meta-portfolio that has its own asset allocation.
So, I do the same calculations on the meta-portfolio using target allocation to each currency. An important difference is that he meta-portfolio has higher trading costs than the sub-portfolios have. When using the idea of converting currency by buying and selling a stock that trades in both Canadian and U.S. dollars, rebalancing requires at least twice as many trades, and the total spreads have to include the spreads on trading the inter-listed stock.
So, instead of c=$10 for regular rebalancing, I use c=$20 for currency rebalancing, and instead of a value close to s=0.0005 (2-cent spread on a $40 ETF), I use s=0.002 for rebalancing with the ETF DLR because the spreads are about 2 cents on a DLR price of about $10. The result is that rebalancing between currencies happens less often than rebalancing in the sub-portfolios.
It took me a while to work all this out, but now I don’t have to pay much attention to my portfolio. When I have some money to add, I buy the asset class that my spreadsheet says is furthest below its allocation, and I periodically check one of the cells for the word “rebalance” glowing in red. Only when I see red do I have to investigate further and make some rebalancing trades.
My own spreadsheet is too specific to my situation, but if there is interest I may put together a generic spreadsheet that captures the ideas here.