Why rebalance your portfolio periodically?

Thank you for the warm response to my asset allocation and the portfolio suggestions posts. In this post, I want to introduce another important concept in managing your personal finances: rebalancing your portfolio.

Rebalancing is an integral part of your asset allocation management. Because assets within your portfolio grow at a different rate, the portfolio as a whole needs to be rebalanced periodically to maintain its risk exposure and its growth potential.

For example, imagine that you have Vanguard Total Stock Market Fund Admiral (VTSAX) and Vanguard Total Bond Fund Admiral (VBTLX) in your portfolio. Your stock fund gained 15.96% this year and 14.2% every year in the last five years, while your bond fund gained 0.33% this year and 2.1% in the last 5 years. If you started with $1,000,000 in your portfolio at 70/30 split (stock/bonds) your portfolio would look like this initially, after 1 year, and after 5 years:

$1,000,000 to start initial investment initial AA 1 yr 1 yr AA 5 yr 5 yr AA
VTSAX

$700,000

70%

$811,720

73%

$1,359,654

80%

VBTLX

$300,000

30%

$300,990

27%

$333,949

20%

AA = Asset Allocation; VTSAX= Vanguard Total Stock Market Fund; VBTLX= Vanguard Total Bond Market Fund

If you made your investment 5 years ago, your asset allocation changed from a 70/30 split to a 80/20 split without any action on your part.

Why is rebalancing important?

  1. As a result of that shift in your asset allocation, your portfolio is now exposed to higher risk than you have planned. Rebalancing corrects that risk exposure. Rebalancing is especially important in a market where one asset is clearly making more gains than the other. Since we constructed our asset allocation with our risk tolerance and goals in mind, we do not want to have large shifts in their portfolio representation.
  2. The example above assumes we are in a bull market (which we have been for a long time). If the example above took place in a bear market, our stock fund would have decreased in value compared to our bond fund. As a result of a downtrending stock market, your portfolio may be less aggressive than you had desired, thus requiring rebalancing.

Those looking closely at the math will notice that, so long as the bull market continues, rebalancing decreases future gains. While it is true, neglecting to rebalance exposes you to higher risks. As I mentioned in my previous posts, higher earnings potential and higher returns are linked, so you have to make a personal decision about your risk aversion at a given point in your life and construct your portfolio accordingly (most people will take on less risk as they approach retirement). I personally rebalance my portfolio once a year to two years. It doesn’t have to be too frequent as the actual act of rebalancing require some consideration. Please follow my next post on how to rebalance your portfolio.

What do you think? How often do you rebalance your portfolio? Interested in reading more on how to manage your own finances? Follow me. 

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2 comments

  1. Good topic! We rebalance once a year in January. Rather than selling any of our existing funds to achieve the desired balance (and thereby triggering capital gains in our brokerage account at worst, or at a minimum a hassle in our tax deferred accounts), I slightly adjust our future purchases to achieve the desired allocation.

    For instance, we have an AA of roughly 75% US Total Stock Market, 10% Int’l Total Stock Market, 10% Emerging Market, and 5% REITs. Since REITs underperformed the past few years, I increased my future purchase % with monthly contributions to 8% to adjust gradually over time.

    Like

    1. That’s a great way to rebalance.
      You are not investing in bonds at all? That’s an aggressive asset allocation, my friend. I also think REIT is a good deal. I adjusted my AA for the first time in a couple years and upped my REIT to 10%.

      Like

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