Rebalancing is a key consideration for any long-term investor. It involves selling some asset types and buying others, to achieve the appropriate mix. This sounds simple, but in practice it’s trickier than on the surface. The appropriate mix needs to be based on your tolerance for risk versus your desired return; but sometimes taking too little risk in the short term may come back to bite you in the long term. You need to decide how often to rebalance. Over time your target risk may change. And you need to choose which specific assets to buy and sell.

What are we rebalancing?

We first need to decide how we define rebalancing for our own personal purposes. One way of doing this might be to determine in advance the percentage of each asset in our portfolio. Then rebalancing involves selling the best-performing assets and using the proceeds to buy more of the worst-performing ones.

Another approach we could take is to pre-determine fixed percentages for asset classes, such as equities, bonds, cash, commodities, etc. Rebalancing would then involve selling assets from the best-performing asset classes and using the proceeds to buy assets in the worst-performing classes. In this case, we’d still need to decide which specific assets to buy and sell.

Our EvolveMyRetirement® app models rebalancing by means of a heuristic. We assign a desired numeric investment risk value to the entire portfolio, which can range from 0 to 100. We configure assumptions for the lowest and highest risk values (i.e. 0 and 100) regarding risk versus reward (we do this by specifying the mean and the standard variation). For all intermediate values (i.e. 1 to 99), the software calculates the risk and reward using a statistical formula. With this approach, the app assumes that the user does the necessary short-term rebalancing to maintain the risk score. It achieves long-term rebalancing by simply varying the investment risk setting for the entire portfolio. To put a strategy that’s based on this into practice, we need to make decisions about buying and selling specific assets, guided by the target investment risk at the particular point in time.

When to rebalance

Based on the heuristic that EvolveMyRetirement® uses, rebalancing would take place continuously. Of course, in practice that would make no sense. Rebalancing too often, such as daily, would incur trading fees that would drain away our portfolio value. Instead, we need a more sensible approach.

One way could be to rebalance at set time intervals, such as monthly, quarterly or yearly. The advantage of this approach is its simplicity. In between rebalancing, we can just forget about our portfolio. It’s analogous to pound cost averaging (or dollar cost averaging as it’s called in the USA) in that it helps us avoid timing the market.

Another approach is to set percentage bands to assets or asset classes. As soon as a valuation goes outside its band we rebalance. The narrower the bands, the more often we’d have to rebalance, but the closer we’d remain to our target. Unlike using fixed time intervals, we’d need to keep an eye on our investments with this approach. We could also use a hybrid approach, in which we’d check our portfolio at set intervals, but only rebalance if valuations had strayed outside set ranges.

Rebalancing and the bucket strategy

In recent years the so-called ‘bucket strategy‘, has become quite popular. Rather than treating all your investments as a single portfolio, you split them into two or more buckets. A major benefit of the bucket strategy is the peace of mind our cash bucket can give us in bad times, when we avoid selling from our other buckets that may have incurred losses.

If used correctly, and combined with rebalancing, the bucket strategy can be a good practical approach. But it isn’t a panacea, and it has some risks if used in the wrong way. It can be tempting to make the flow of funds strictly one-way, from higher risk buckets to lower risk buckets. Let’s assume for simplicity that we have just two buckets: cash and equities. Let’s say we aim to keep the cash bucket at a constant level of £50,000. Then in normal times, whenever we draw funds from our cash bucket, we sell enough equities to replenish the balance. The idea is that if equities suffered a downturn, we’d delay replenishing the cash bucket until equities started to rise again.

From the perspective of rebalancing our entire portfolio of investments, which includes all buckets, there’s something missing. If our equities were to fall in value a lot, we could find ourselves overweight in cash. In this situation, the principle of rebalancing tells us we should use some of our cash bucket to buy more equities in the equity bucket, thus restoring the balance. But doing this requires both discipline and courage. The idea of moving money out of our rainy-day cash bucket back into riskier assets during a downturn may be counter-intuitive. The main idea behind the bucket strategy is to sell high rather than sell low. But the principle of rebalancing reminds us that it’s also important to buy low, which is often overlooked. Sometimes we need to resolve a conflict between what the bucket strategy and the principle of rebalancing are telling us to do.

Changing risk exposure over time

Target-date funds were invented when annuities were just about the only game in town for retirees. With a target-date fund, the portfolio is gradually rebalanced from high risk to low risk assets, until a specified date. The original goal was to reduce the risk of having a shortfall on the target date, which is when the intention was buy an annuity. Once drawdown became a viable alternative to annuities, the benefit of target-date funds became less clear. The point of drawdown is to keep the bulk of one’s funds invested after retirement. Permanently removing all risk from a drawdown fund at the start of retirement may guarantee failure, since future growth will be miniscule.

When planning for drawdown, it’s not obvious whether any risk reduction is beneficial, whether it should start before or after retirement, or how gradual it should be. These are things that depend on one’s entire personal financial situation.

Putting rebalancing into practice

The strategy (as opposed to tactics) isn’t about how many shares of particular equities we should buy or sell. Rather, it’s about the overall level of risk we should be aiming for, both now and in the future. We can use EvolveMyRetirement® to help us arrive at an optimal strategy. As a refinement, we might also want to identify particular buckets and/or asset classes.

Once we’ve decided on our strategy, we need to turn to tactics. We need to choose specific investments, consistent with our strategy. Diversification is essential, especially for our riskier assets; not just across different companies, but also different sectors and even different countries. Unless we have extensive financial understanding, professional advice becomes essential to avoid the pitfalls.

The investment decisions we make today are unlikely to be fixed for all time. The need for rebalancing will be one reason we’ll make changes in the future. Also, our own personal circumstances may change; what’s right for us today may not be right for us in a year’s time.

Rebalancing: What It Means
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