What is Rebalancing and Why is it Important?

What is Rebalancing and Why is it Important

Photo courtesy of :mrMark:

I’m a big fan of the “buy and hold” investment strategy, which essentially means that you choose your investments for the long-term and stick with them through the ups and downs. There is no trading or moving in and out of the market based on the events of the day.

But even a buy and hold strategy takes a little bit of maintenance. Part of that maintenance is the need to rebalance your investments every now and again.

Today I’d like to talk about the idea behind rebalancing, why it’s important for investing, and how you can do it simply.

What’s the idea behind rebalancing?

The need to rebalance our investments is very similar to the rebalancing need we often face in our personal lives. As an example, most of us probably have an ideal work-life balance that we like to maintain, with so many hours spent on each. But there are times where that gets thrown out of whack.

You may have a big project at work that requires you to put in some extra hours. You may even have to work over a weekend.

On the other side there will be events in your life that take you away from work more than usual. Vacations are a perfect example. Having a baby is another one.

Both of these things will not only throw you out of balance for a period of time, but they should be expected. It’s reasonable to think you’ll have to work more than usual at times, just as it’s reasonable to take time away from work at others.

But in each case you will eventually have to recognize the imbalance and take steps to fix it. Your work project will end and you can get back to being home for dinner. You will return home from vacation and have to get back to your job. You bring your life back into balance.

Your investments get out of balance too

If you’ve chosen an asset allocation that includes different types of investments, such as stocks and bonds, they will occasionally stray from whatever target percentage you pick. This will happen simply because the market returns will cause one or the other to grow or shrink in value.

Let’s say you invest $10,000 with a 70/30 split between stocks and bonds (which just happens to be my own asset allocation). So you start with $7,000 in stocks and $3,000 in bonds.

Now let’s say that over the course of the year stocks do really well and return 20%, while bonds do poorly and lose 5%. At the end of the year your stock portion would be worth $8,400 and your bond portion would be worth $2,850, for a total value of $11,250. How does that compare to your target percentages?

  • Stocks: $8,400/11,250 = 74.7%
  • Bonds: $2,850/11,250 = 25.3%

As you can see, simply because of normal market movements your investments have gotten out of balance.

Why should you care about rebalancing?

Okay, so they’re not at the exact percentages you specified, why should you care?

Well, the truth is that you’ll get different answers on both why you should care and how much you should care.

The argument I agree with is that you should care because you picked your asset allocation for a reason. It represents the balance you wanted to strike between risk and return, and deviations away from that asset allocation take you away from your chosen path. Not rebalancing would be like continuing to work extra hours even though the big project has ended. That’s not what you set out to do, so why would you let it continue?

So the next question is how much you should care about rebalancing. In other words, if your asset allocation drifts by just a couple of percentage points, should that matter? If not, how much should you let it drift before taking action?

Again, there are many different opinions here and I haven’t seen anything that definitively says one is better than another.

Because there isn’t a definitive “best” way to do it, my default recommendation would be to check on your investments once per year and rebalance if the percentages are off by more than 5%. Keep in mind that there isn’t a lot of science behind that recommendation, but that’s because there really isn’t a scientific answer to give. In light of that, I think simplicity should be the rule.

If you’re interested in other opinions, there are smart people who will argue that rebalancing is unnecessary, as well as those who advocate for doing it more often.

How to rebalance your investments

By far the simplest way to rebalance your investments is to hold a single fund that is simply a collection of other funds with a target asset allocation. I give examples of this strategy in my article on how to beat 80% of investors with 1% of the effort. With this strategy you don’t even have to worry about rebalancing because the fund handles it for you.

The next best way to rebalance is to do so with your contributions. When you have new money to put into your investments, simply direct it to the part that has decreased in percentage. So in our example above, you would send your contributions to the bond portion of your portfolio, since it was below your target percentage.

You can also rebalance by selling some of one investment and using that money to buy another. In our example above, you would sell some stocks and use the proceeds to buy some bonds. If your money is within a tax-advantaged account like a 401(k) or an IRA, this is a fine approach. But if your money is in a taxable account then you need to be careful with this approach. There may be negative tax consequences to selling that could wipe out any of the benefits of rebalancing. It’s best to seek out advice on your specific situation before doing so.

Conclusions

Balance is important in all aspects of our lives, and it’s no different in investing. If you’ve done the work of choosing a purposeful investment strategy, then it makes sense to rebalance when necessary to make sure you stay on track.

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  • Mrs PoP @ PlantingOurPennies November 25, 2013

    That’s one of the reasons I like inexpensive Target Date funds so much, especially when you are young. They are constantly rebalancing by buying underlying shares in the appropriate pile(s) to make sure the portfolio is balanced in the most efficient way possible. It’s great for people that don’t want to have to worry about it.

    • Matt @ momanddadmoney November 25, 2013

      While I 100% agree with you that using a single fund is a great way to go, I will say that it’s probably not the most efficient. Having separate funds would allow you to do some things with taxes that you can’t really do with one fund, but I think that for most people the simplicity of a single fund is probably a bigger benefit.

  • Brian @ Luke1428 November 25, 2013

    Great stuff here Matt! We check on our investment balance at least once a year. My feeling is that it’s important to be aware of and adjust but not to get too worked up about it. You could fret about this once a month and frustrate yourself to death always trying to maintain the perfect balance.

    • Matt @ momanddadmoney November 25, 2013

      Totally agree. I actually check ours pretty often (about once a week), but that’s more because I’m interested in having detailed records to look back on. I haven’t actually had to rebalance yet other than taking things into consideration when I’m making a contribution.

  • DC @ Young Adult Money November 25, 2013

    It’s hard to disagree with you. Like Mrs PoP, I like Target Date funds because they do the re balancing for me and allows me to be a passive investor. I’ve tried hard to simplify investments the past few years and I’m glad there are funds out there who do the work for me.

  • John S @ Frugal Rules November 25, 2013

    Good stuff here Matt. I think rebalancing is vital, and that you need to find a method that works best for you – though I tend t default to the once per year mindset myself. If you’re watching your portfolio semi-regularly, say maybe once every few months, then it really can be very simple – or you can make it even simpler by choosing specific funds. That said, you’re right on about the selling to buy philosophy. I’ve seen way too many have good intentions only to get bit by the tax man because it was in a non-retirement account.

    • Matt @ momanddadmoney November 25, 2013

      Taxes are always lurking in the background. You can really use them to your benefit but they can also take a pretty big bite out of your money if you’re not careful. We do watch our investments pretty regularly but other than a small consideration on contributions I haven’t had to rebalance yet.

  • Laurie @thefrugalfarmer November 25, 2013

    More great info here, Matt, as we prepare to jump into the world of investing. I can’t say I’m not nervous still, but all of these little tidbits of advice sure do help. 🙂

    • Matt @ momanddadmoney November 25, 2013

      The good news is you don’t have to learn all of it all at once. You can get comfortable with one thing at a time and only add complexity if you really feel like it will help.

  • Ree Klein November 25, 2013

    Hi Matt,

    Rebalancing has always been a difficult thing for me for two reasons. First, I’m reluctant to sell something that is doing well even though intellectually I KNOW that selling high and buying low is a good thing.

    Second, because my investments tended to be splattered all over (work 401k, Vanguard, I Bonds, corporate and municipal bonds, money markets, etc.) It was hard to get a handle on exactly what my true mix was. Those two conditions made it easier for me to stick my head in the sand!

    I should probably take the time to get that figured out…thanks for the nudge!

    • Rich Ellinger November 25, 2013

      The good news is there are bunch of emerging new companies that make it easy to a) see all your investments in one place and b) alert you when you need to re-balance.

      • Ree Klein November 25, 2013

        Hi Rich, I currently upload my account data from each financial institution into Quicken; however, it doesn’t show me a breakdown of how my funds are allocated. Maybe it would but I just haven’t taken the time to figure it out.

        I’m reluctant to use tools like Mint because I won’t put my log on information out “there” despite promises of safety and security. I don’t give out the keys to my house, either! Do you know of any companies offering good tools that don’t require them to have access to my log on info?

        • Rich Ellinger November 25, 2013

          Hi Ree,

          To be effective, the services I know of want you to connect your accounts. Some will let you manually enter the data, but it will quickly go stale and keeping it up to date by hand would be painful.

          Most of these services only have read-only access to your data and rely on third party aggregation services like Yodlee and Intuit to fetch your data. So your danger is limited to someone hacking these 3rd parties and stealing your usernames/passwords.

          While certainly not out of the realm of possibility, as a tech guy myself, I would tell you it is much more likely that someone successfully attacks your personal computer and steals your usernames/passwords from quicken than them breaking into a service like Yodlee’s.

          • Ree Klein November 25, 2013

            …I’m so chicken that I don’t store them on my computer or in Quicken…it’s good old paper and pencil for me! Thanks for the follow up 🙂

    • Matt @ momanddadmoney November 25, 2013

      It can definitely be tough with multiple funds. I’ve never really liked the online tools for this purpose because I haven’t found one that lets me customize my target asset allocation the way I want. So I actually keep track of my trades (of which there are mostly just purchases) and dividends and such in an excel I created and track things that way. But it’s also simpler for me because I only use 4 funds so there aren’t a lot of different things to keep track of, even though we do have several accounts.

      If you want some help creating a spreadsheet, this page has a couple of good examples you can download under the “External Links” section: http://www.bogleheads.org/wiki/Rebalancing

  • Joe@IGotOuttaDebt.com November 25, 2013

    Timely advice Matt, I’m in the process of doing that just now

    • Matt @ momanddadmoney November 25, 2013

      Interesting. What’s currently out of balance for you?

      • Joe@IGotOuttaDebt.com December 4, 2013

        I’m at a point where one of my funds has done REALLY well, up 33% since last year, 102% since ’09. What I’m trying to do now is rebalance so I’m more evenly distributed. But it’s HARD taking out of something that’s done so well!

        So that one is close to 40% of my portfolio, but I *should* take it down and spread it out.. what do you think?

        • Matt @ momanddadmoney December 4, 2013

          Hey Joe. I can definitely understand that it’s tough to sell a winner. I think it all comes back to what your original plan was. If your original plan was to rebalance when things got to a certain point, and you’re now at that point, then I think you should rebalance. Otherwise you’re essentially trying to time the market, which history tells us will likely not end well. Good luck!

  • Shannon Ryan November 25, 2013

    Rebalancing is very important and something that is often overlooked. It can be hard for some investors to understand why they should pull back if, as in your example, stocks are over performing. They figure what’s the big deal, my account is going up and that is all that matters. As much as I certainly like to see investments grow, that only paints part of the picture. Great points, as always, Matt!

    • Matt @ momanddadmoney November 25, 2013

      I would actually get excited by the opportunity to rebalance simply because I’m a nerd and I haven’t really had a chance to do it yet. But I definitely understand why it can be difficult. I just try to keep the mantra “this too shall pass” in my mind during times like that.

  • Pretired Nick November 25, 2013

    Rebalancing really helped me out at certain points in the past. I rebalanced before a few market crashes at least twice and it saved me a ton in losses. That said, people focus on taking the profit off the table, but the buying of cheap stuff is arguably more important over the long haul. Great post!

    • Matt @ momanddadmoney November 25, 2013

      Nice timing! I’ve seen different arguments about how much it actually helps your returns over the long run, but in any case I like the automated buy low/sell high. For me though it’s mostly about being purposeful in what I’m doing.

  • Done by Forty November 25, 2013

    Thanks for this reminder, Matt. We’ve yet to rebalance our portfolio ever since settling on the Simpleton’s Portfolio…mostly out of laziness and not really being sure if it is the right move. I love the idea of setting a threshold (e.g. 5%) rather than just rebalancing once a year regardless (though I’ve heard some convincing arguments for doing that, too).

    • Matt @ momanddadmoney November 25, 2013

      There are plenty of arguments in every direction. I think the important thing is just to find something that you can apply consistently.

  • Andrew November 26, 2013

    Like Mrs PoP and DC, I do like the Target Date funds so I don’t have to worry about rebalancing. Most of the IRA is in the Vanguard Target funds but my deferred compensation plan is in various Vanguard index funds (they didn’t offer the Vanguard target retirement fund). I have been too lazy to rebalance and like Ree…I do sometimes have a hard time selling something that is doing well. How often would you rebalance? Or do you wait for the balance to reach a certain level to rebalance?

    • Matt @ momanddadmoney November 27, 2013

      There’s no one “right” way to do it. Personally I actually check my investments every week against thresholds I’ve set, but that’s probably overkill and I haven’t actually even had to rebalance yet. I think the default should probably be once per year, and potentially only if they’re a certain amount out of line. I don’t think small variations should be concerning. It’s more about making sure you’re not getting way off track.

  • Grayson @ Debt Roundup November 26, 2013

    Nice job breaking this down Matt. Rebalancing is a great tool and easy to do. Many people don’t know about it, so this resource is excellent.

  • Stefanie @ brokeandbeau November 26, 2013

    I’m a big fan on the target retirement date funds that adjust for you. Other than those ALL of my investments are in stocks. Even though I’m in my 20s and have the time for more risky investing now, I really need to work on diversification.

  • Charles@Gettingarichlife November 26, 2013

    Rebalancing is one of my big challenges. In a bull market everyone looks like a genius and you don’t want to miss out on bigger gains. I agree that the key to long term growth is forcing yourself to rebalance to smooth out your portfolio.

  • Debt and the Girl November 27, 2013

    This is all great information. I am still new to the investment game but it is something I am hoping to get better versed in. Thanks for the tips!

  • Jacob @ iHeartBudgets November 27, 2013

    I’ve started with target date funds, but will move toward an asset allocation that I am comfortable with and self-manage like you described above. Rebalancing is easy, but you need to be mindful of your goals, and how your asset allocation should always reflect your goals and tolerance.

    Here’s to hoping I get off mu duff and start self-managing in the next few months 🙂

    • Matt @ momanddadmoney November 27, 2013

      Haha, I enjoy managing my own funds because it satisfies the control freak in me. It also does give you a little more opportunity to take advantage of our tax laws. But at a high level I’m under no illusion that I’m doing anything significantly better, or possibly even any better, than picking a target date fund and letting it ride.

  • Matt @ momanddadmoney November 27, 2013

    I’d be interested to hear if you like using mint for this kind of thing. I haven’t found it or any other online service like it to be incredibly helpful for how I want to manage my investments, but other people might think differently. I’d love it if you kept me updated.

  • MoneySmartGuides December 3, 2013

    Great post! I make it a point to review my investments for rebalancing purposes annually. Instead of making trades in my taxable account and realizing potential gains, I change my future investments so that more goes towards those that were underperforming. But, this doesn’t work all of the time.

    • Matt @ momanddadmoney December 3, 2013

      Re-directing contributions to underperforming investments, as you describe, won’t work all of the time but I think it will work more often than not. At the very least, it’s a great default to get you through most situations.

  • Andrew May 6, 2016

    Hi Matt,

    With regards to rebalancing, when would we add new funds into our index funds, and when we would sell the over-performing indexes to buy up the laggards?

    Most people say re-balancing involves the injection of new funds to buy up the laggards, but by doing that, and not selling the over-performing indexes, we wont be able to profit from sale of “high priced” stocks. On the other hand, by selling and buying, where would the injection of new money be required?

    Is rebalancing and adding new money into the initial investment amount the same thing?

    Thank you so much!
    Andrew

    • Matt Becker May 6, 2016

      Good questions Andrew. Using new funds to buy the laggards is essentially exactly the same as selling the out-performing funds to buy the under-performing funds. Think of it this way. You could either:

      1. Spread your new contributions out over all investments, then sell and buy. Or…
      2. Use the new contributions to buy the under-performing investments directly.

      Either way you end up in the same place. And if you’re talking about money in taxable accounts, the second route is actually better because it avoids taxes on any sales.

      Of course, in certain situations your new contributions may not be enough to completely rebalance. In that case you could make up for any difference by buying and selling.

      As for when do to actually trigger a buy/sell rebalance, here’s a good article that goes in depth on how to optimize it: Finding The Optimal Rebalancing Frequency – Time Horizons Vs Tolerance Bands. But for all intents and purposes, once per year is plenty good enough in most situations.

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