Recently, the Stingy Investor pointed to an article whose title caught my eye: The Academic Failure to Understand Rebalancing , written by mathematician and economist Michael Edesess.  He claims that academics get portfolio rebalancing all wrong, and that there’s more money to be made by not rebalancing.  Fortunately, his arguments are clear enough that it’s easy to see where his reasoning goes wrong. Edesess’ argument Edesess makes his case against portfolio rebalancing based on a simple hypothetical investment: either your money doubles or gets cut in half based on a coin flip.  If you let a dollar ride through 20 iterations of this investment, it could get cut in half as many as 20 times, or it could double as many as 20 times.  If you get exactly 10 heads and 10 tails, the doublings and halvings cancel and you’ll be left with just your original dollar. The optimum way to use this investment based on the mathematics behind rebalancing and the Kelly criterion is t...

Investors often seek to maintain fixed percentage allocations to the various components of their portfolios.  This can be as simple as just choosing allocations to stocks and bonds, or it can include target percentages for domestic and foreign stocks and many other sub-categories of investments.  Portfolio components will drift away from their target percentages over time, requiring investors to perform trades to rebalance back to the target percentages.  A natural question is whether rebalancing produces profits, and if so, how much. A long-time reader, Dan, made the following request: I have a topic request. On the subject of portfolio rebalancing, I have read your many posts and whitepaper [see Calculating My Retirement Glidepath ]. I have actually implemented something similar (but not exactly the same) myself.  I saw in one blog post, cannot find where, that you said something to the effect of “my rebalancing trades last year produced a profit”. My topic request...

Index investors usually choose some target allocation percentages for the different asset classes of stocks and bonds in their portfolios.  As markets move, these percentages can wander, so investors need to make trades to get back to their target percentages, a process called rebalancing.  Long-time reader JC asked how rebalancing changes when there are no trading fees. Younger people with smaller portfolios typically rebalance only when they add new money to their portfolios.  This can be as simple as buying more of whichever asset class is furthest below its target percentage.  Those with larger portfolios can’t always keep balanced with new money; sometimes they have to sell an ETF that’s been rising to buy another that’s fallen behind.  One way to do this is to rebalance based on the calendar, perhaps once per year.  With this approach, having no trading fees makes little difference in how investors rebalance. More ambitious investors may try “threshol...

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 recently improved a scheme that I have now fully automated in my portfolio spreadsheet. Instead of obsessing over my portfolio’s returns, a script emails me when 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 reb...

The COVID-19 stock market crash has certainly thrown off the balance of my portfolio.  Like most investors, my fixed-income savings haven’t done much, but my stocks have been jumping around crazily.  So far, I’ve stuck to my plan to rebalance my portfolio to fixed percentages of stocks and fixed income whenever they get out of range.  This has worked out surprisingly well, but I’m not feeling particularly good about it. When I was working, I had an all-stock portfolio invested in a few broadly-diversified Vanguard index funds.  I didn’t have to rebalance my portfolio much, because my stock ETFs tended not to get wildly different returns.  Now that I’m retired, I have an allocation to fixed income (cash, GICs, and short-term government bonds). My fixed income definitely gets different returns from stocks, particularly during the recent stock crash.  I’ve had to rebalance a few times. The thing about rebalancing is that it has you buying whatever has gone...

I’m no market timer, but my investing spreadsheet looks like one. I’ve coded just about all of my investment decisions into one spreadsheet. Whenever I add new savings, the spreadsheet tells me what to buy to bring my portfolio back to its target asset allocation percentages. However, if we look at the rebalancing decisions in isolation, they look like brilliant market timing. It’s no secret that the Canadian dollar has been extremely volatile compared to the U.S. dollar over the past year. I had no idea this would happen. I didn’t make any predictions. I don’t know what will happen in the future. But my rebalancing spreadsheet looks like it made good predictions. Before the Canadian dollar began dropping, I was adding new money to U.S. stocks to get my portfolio back to its target percentages. After the Canadian dollar dropped, I was buying Canadian stocks. The recent run-up in the Canadian dollar has me back to buying U.S. stocks. I’ve consistently bought low. How can ...

All the evidence says that the vast majority of us aren’t good active investors. Our choices tend to be worse than random, and we pay investment costs on top of this. Even index investors can have these problems. Here I explain how I’ve tried to automate my investment decisions as much as possible to take myself out of the loop. Investors have many worries. Is now a good time to be buying stocks? Should I be selling now? Are there better mutual funds than the ones I own now? Should I shift more money into bonds? Less? Unfortunately, the evidence shows that most of us make worse than random choices when we try to answer these questions. It’s tough to admit that we can’t beat a coin flip. My response to this dilemma is to ignore my opinions on the market and invest in indexes. And as long as I’m not trying to beat the market, I maximize my returns with low-cost highly-diversified index ETFs. But even after making this decision, investment choices can creep back in. For...

Investors find many ingenious ways to underperform stock indexes. Sadly, many have no idea that their brilliant moves actually work out badly over time because they don’t track their returns accurately. Among the ways that investors manage to harm their portfolios is what I call “anti-rebalancing”. The idea of rebalancing your portfolio is that you start with fixed percentages of various asset classes, and when they drift away from the fixed percentages, you bring them back in line. For example, suppose Beth holds 4 funds in equal amounts: Canadian stocks, U.S. stocks, foreign stocks, and bonds. Every so often she checks which fund balance is higher than the others and which are lower, and she makes some trades to get the amounts back in balance. This sounds easy enough in theory, but isn’t so easy in reality. After the explosion of U.S. stocks in 2013 and the relative underperformance of foreign stocks, Beth is supposed to sell some of her U.S. stock fund and buy more of her ...

Please see the updated post on this subject that computes better thresholds in certain cases. 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...

Many commentators preach the benefits of choosing an asset allocation strategy, sticking with it, and rebalancing regularly. This is good advice, but some investors overestimate the benefits of portfolio rebalancing. If done properly it can certainly increase returns, but the gains are usually quite modest. Consider the following example. Emily starts with a balanced portfolio worth $22,000, half in a stock ETF and half in a bond ETF. Initially, both ETFs trade for $50. Emily’s starting portfolio looks like this: Stocks: 220 shares @ $50 Bonds: 220 shares @ $50 Now, suppose the stock ETF goes up 10% and then comes back down again. If Emily does nothing, her final portfolio value will be $22,000, the same as it was at the start. But, if she rebalances, she will make some money. Let’s see how much she can make (ignoring commissions and spreads for now). After the stock ETF has gone up 10%, Emily’s portfolio looks like this: Stocks: 220 shares @ $55 Bonds: 220 shares @...

Part of the theory behind maintaining a fixed percentage allocation of your portfolio to different asset classes, like stocks and bonds, is that when markets are volatile, you can increase returns by rebalancing.  Unfortunately, there is no immediate return from rebalancing. To show that rebalancing has created a profit, you need to take into account not just your most recent rebalancing trade, but also the last time you rebalanced in the other direction.  If you do the calculation, it will show whether the second to last rebalancing trade produced a profit, but the most recent one won't show a profit until the next time you rebalance in the other direction. This situation creates a problem of a delay from effort to reward.  We're much better at doing things that give immediate gratification.

As my own investment portfolio has shifted from individual stocks to index ETFs, I've given more thought to portfolio rebalancing (see my earlier post on a rebalancing trap ). I've discovered a number of barriers to the seemingly simple act of rebalancing a portfolio. Life would be simpler if we had fewer accounts. Here are some common investment account types: – Regular taxable – RRSP – Locked-in RRSP (withdrawn from a former employer's pension) – Spousal RRSP – TFSA – RESP For a couple there would be two of some of these accounts. When there are so many accounts, rebalancing can become quite complex. What starts in theory as a single sell order and a single buy order may become multiple trades in practice. We have reason to prefer holding certain assets inside or outside an RRSP for reasons such as taxes on interest or dividends. If rebalancing requires buying a particular asset, but the available cash is in the wrong account, then tax planning becomes...

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...

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...