The most crucial component of any comprehensive financial plan is developing an investment strategy that will match your financial goals. At its most basic form, your investment strategy includes determining the right balance of stocks and bonds in your portfolio. Everyone has their own unique circumstances and goals, each of which will be a driving force behind your target percentages. However, once your funds are invested, how do you know when to rebalance to your targets? This question is more pressing during times when markets experience excess volatility.  Should I rebalance once a year? Once a month? Every week? How far away from my target allocation should I let my portfolio drift?

With the stock market being unpredictable, there is no one “perfect” approach to rebalancing your portfolio. However, there are some measures that can be taken to effectively and efficiently manage your allocation. Every financial advisor has their own set of parameters they monitor when deciding to rebalance a portfolio.

Develop your Investment Strategy

To meet your financial goals, you need to start by developing an investment strategy. You will need to establish which types of investments you will hold, and how much of your portfolio will be invested in each. This can be done on a broad level (stocks vs. bonds), sector-level (large US stocks, small US stocks, international stocks, REITs), or even security level (individual stocks, mutual funds, ETFs). Once you have your target allocation set, and your funds are invested, these investments will fluctuate in value, causing your actual allocation to be different than your target allocation. This is normal.

One thing the individual investor is prone to is their emotions. When people see their investments start to drift away from their targets, their performance will provoke an emotional response – both negative and positive gains can be perceived optimistically and pessimistically. Some may view a decline in a stock’s value as a reason to sell, some may view it as a good time to buy. Some may view an increase as a time to take money off the table, whereas others may view it as a time to buy in. Emotional responses are perfectly normal and certainly understandable when they affect a large portion of your individual wealth. However, letting emotions tell you when to rebalance is a bad strategy.

How can you eliminate the effect of emotions on your portfolio management technique? By determining a plan and setting parameters ahead of time. Developing an objective guideline for managing your portfolio in both favorable and unfavorable market conditions can deter you from making panicked decisions that may harm the performance of your portfolio and may result in trading fees and taxes. Consulting with a qualified financial planner will help you eliminate your personal and emotional biases from your investment portfolio when the stock market starts to get volatile.

Why should you rebalance?

In an effectively diversified portfolio, each investment will perform better or worse than the next at any given time. This will cause your overall portfolio allocation to drift away from the initial target mix that you set for your portfolio – the one that suits your financial needs best. When this happens, it is important that you take action to move your allocation back toward its target. Failing to do so will leave your portfolio more aggressive or conservative than you are comfortable with.

One important thing to note regarding your portfolio allocation is that an effectively diversified portfolio containing mutual funds from multiple different and uncorrelated sectors will perform very different than a portfolio that is concentrated in a few individual stocks, or one single sector. If your investments are concentrated in individual stocks or one sector (ex: health care, technology, only companies in Europe, etc.), you will be subject to much more risk. For each added unit of risk, you will be subject to wider price swings; while this can be beneficial in a strong market, it can also hurt you just as quickly. By diversifying your portfolio with uncorrelated investments, you will spread out your risk across different sectors. While this may limit upside potential when one sector performs better, your overall risk/return ratio may improve.

By rebalancing, you are keeping your allocation in check such that it will continue to perform as you intended. Rebalancing is also a great way to take profit from investments that have performed well, and reallocating funds to those in sectors that have underperformed, buying more shares while the funds in those sectors are relatively “cheap.”

One piece to note here – this tactic is geared towards portfolios that use mutual funds. While past performance does not guarantee future results, historically, an investment in the overall stock market has consistently grown over the long term. This is because the market is diversified across thousands of different companies, with new companies forming and old ones dissolving each year. When a sector or asset class declines for a period of time and is now underweighted in your portfolio, it can make sense to allocate funds from your overweighted mutual funds to the declining sector or asset class, as its performance will likely revert to its historical average.

We cannot, in the same manner, say that individual companies have always increased in value over time – they can, and have, collapse. In this instance, you could be putting more money into a sinking ship. Owning highly concentrated positions in individual stocks is very risky because of single stock risk. This can be mitigated by using funds that own hundreds or thousands of different stocks.

It is also important to ensure you aren’t rebalancing too quickly, or too frequently. This is where your rebalancing plan and parameters come into play.

How often should you rebalance?

Individual investors should review their portfolio and rebalance it periodically. Once again, there is no “perfect” time to rebalance your portfolio, but there is such thing as too often, and too infrequently. Rebalancing your portfolio too often will cause you to incur excess trading fees (fees that are charged each time you place a trade to buy/sell a security). At the other end of the spectrum, not rebalancing your portfolio enough may result in your portfolio allocation drifting too far from target, usually overly increasing your risk. Your rebalance frequency may also depend on the types of investments that you hold; those that trade derivatives or take short positions will want to look at their holdings more frequently than the average investor using a buy-and-hold technique with diversified mutual funds. For the average investor, daily is too frequent, and annually may not be frequent enough.

For individual investors who are not financial professionals, reviewing your portfolio once a quarter is an appropriate rule of thumb. Reviewing your portfolio once a quarter is a feasible timeline for two reasons. First, if you review your portfolio more frequently than once a quarter (ex. Weekly or daily), short term volatility may cause you to rebalance more often than needed. Rebalancing based on short-term volatility is much like trying to time the market – the issue with trying to time the market is that you need to be correct, two times. You need to correctly time the market correctly when selling (selling when the fund is at its highest point, which cannot be known for certain), and re-entering the market when the fund is at its lowest (buying when the fund is at its cheapest, relatively). This is very risky, and it is impossible to tell which direction the stock will move in the future. By reviewing your portfolio less frequently, you can let the market smooth out the short-term volatility (and avoid those transaction fees!).

The second reason why reviewing your portfolio quarterly is a good rule is to make sure you are not neglecting the portfolio. If you wait too long to look at your portfolio, some of your investments will start to drift far off target. If they drift too far off target, then your current portfolio allocation will not align with the target allocation you set for it – the specific allocation you set that was necessary to meet your goals. Reviewing your portfolio quarterly is a good balance for making sure your allocation stays on track, but also letting the market take its course. Reviewing does not always mean that you need to rebalance. How can you determine the right time to rebalance?

At what point do I rebalance my portfolio?

We created our investment strategy, set our target allocation, invested our funds. Three months have passed, and you are now reviewing your portfolio for the first time. Your investments have all changed in value, some have grown a lot faster than others. When do I know when to rebalance?

We have talked about investments drifting “too far” from their target allocation, but what does this really mean in practice? Once again, there is no sole perfect answer, and each investor has their own preferences depending on their portfolio holdings. When looking at how to determine when to rebalance your portfolio, we are looking at the current value of the specified fund in comparison to what it should be based on your initial portfolio allocation mix.

Just like how reviewing your portfolio can be too frequent or infrequent, the same can be said for rebalancing your portfolio. For example, lets say your target mix (at a high-level) for stocks and bonds are 80% stocks, and 20% bonds. If your stock allocation moves up 1%, it would not make sense to rebalance from 81% stocks, back to 80% stocks. However, if your stock allocation increases to 90%, then it may make sense to rebalance back to 80%. Like we mentioned before, rebalancing too frequently will result in placing too many trades, incurring a lot of transaction fees, as well as not giving the market enough time to smooth out some of that short term volatility. On the flip side, waiting too long will let your portfolio drift too far from your initial allocation, which causes your portfolio to no longer align with your investment goals.

At Milestone, one way we analyze whether or not to rebalance is by using a relative variance measure. Relative variance can be calculated by taking the current value of the fund, subtracting the target value based on your current portfolio value, and then dividing the difference by that target value. For example, an individual investor could use a 20% relative variance rule. Lets assume they invest 20% into an S&P 500 index fund, and 10% into a Russell 2000 index fund. Using this 20% variance rule, the investor would look to rebalance the S&P 500 fund when the value is either below 16% of the current portfolio value, or above 24%. For the Russell 2000 index fund, they would look to rebalance when the fund value is either 8% of the current portfolio value, or above 12%. By using this method, you are using an objective measure to rebalance your portfolio, eliminating all emotional and personal biases from your rebalancing process. This is especially beneficial when the market is volatile, ensuring that you are not moving too quickly (or too slowly) to rebalance. You also want to factor in non-investment related decisions, such as the tax impact, when trading in a non-retirement account.

Summary

Rebalancing is vital to any successful financial plan but can be harmful if done in the wrong manner. At Milestone, we believe that rebalancing is done best when reviewing the portfolio often but trading as infrequently as possible.

Developing an investment strategy and setting objective parameters for your portfolio reviews is an effective way to remove personal and emotional biases from your investment process, especially during times of market volatility. Sticking to your original investment plan is crucial to staying on track with your financial goals. Rebalancing is key to ensuring your portfolio continues to align with your desired risk profile to achieve those goals.

The beauty of working with a financial advisor is that they take these tasks (and many others) off your plate so you don’t have to think about them. Managing your investments and rebalancing can be challenging. If you would like help with your investment management, and your overall financial plan, please reach out to our team.