Portfolio Rebalancing: What is it? Why Bother?

balanced portfolio

Some tasks cause decision paralysis amongst those making the jump into DIY investing. One is determining their risk tolerance and asset allocation. Another is deciding which funds to buy in what accounts to achieve that in a tax-efficient way. I have made a simple three-fund portfolio building tool and a more complex one to help with that. The specter of another portfolio management task can stop people before they even start – fear of rebalancing.

This post and the next few will shine some light onto this beast and hopefully make it less scary. I am also making an online tool to help make the mathematics of the task simple. Even across account types.

What is investment portfolio rebalancing?

When we set up our investment accounts, we diligently choose an asset allocation to suit our needs. That includes as much equity as we can stomach to maximize long-term investment returns, tempered by enough bonds to smooth the volatility so that our emotional investor beast doesn’t get provoked and smash the portfolio. We also buy different types of equities to minimize investment risk through diversification.

Unfortunately, our investments then grow at different rates and that nicely constructed asset allocation drifts out of alignment over time. More sedate bonds tend to grow more slowly while equities can grow rapidly and have periods where they can drop spectacularly. Even different holdings that will grow at similar rates in the long-run, have periods of growth and retraction at different times.

why rebalance portfolio

Rebalancing is a combination of buying some of the laggards and sometimes selling some of the winners in our portfolio to bring our asset allocation back to where we intend it to be.

That can be simple, like within a single account. It could also be more complex, such as rebalancing across different accounts to keep an overall asset allocation for the total portfolio. The math behind that and fear of tax consequences from selling are what often cause people to hesitate. However, even that can be simplified – especially during the accumulation years. The mechanics of when and how to do that will be future posts.

Why bother rebalancing an investment portfolio?

The biggest reason to rebalance is to maintain your desired level of risk.

Equities generally return more than bonds over the long run (~10%/yr vs ~4%/yr over the past 90 years of U.S. data). If left unchecked, your equity allocation would eventually dwarf the bonds allocation. Equities are expected to return more since they have more risk. So, as the equities grow and take over your portfolio, the level of risk (and volatile price swings) would also increase over time. Usually, we want the exact opposite of that.

rebalancing investment risk management

Volatility is riskier as we age. Not just because of coronary artery disease.

As we age, we have less human capital to spend to absorb losses or time to wait for the markets to recover before we need the money to live on. Imagine that you have built a big enough portfolio to retire on and it crashes just as you plan to kick-back and access it. You may need to either live on less or delay retirement until the market recovers.

That may seem like a distant problem to someone starting out. However, the odds of something happening to force an unplanned partial or full retirement also increases once we are “over the hill”. So, deferring rebalancing until closer to your planned retirement becomes increasingly unwise.

Portfolio rebalancing forces us to sell investments high and buy low.

“Buy low and sell high” sounds like a guaranteed recipe for investing success. However, our behavioral hard-wiring makes it hard for us to sell what is doing well (we desire more of it) and pushes us to sell what is lagging (to make the pain stop).

A mechanical approach to rebalancing, with the discipline to follow it, should overcome that. It directs us to sell the assets whose growth has outpaced the others and buy the laggards to bring our allocations back into target. Even with mechanical rebalancing, the results of that in practice are actually more variable.

Rebalancing can increase returns in volatile markets and decrease them in smooth trending markets.

The relative performance of rebalancing is heavily influenced by the time-frame that you look at. For example, in the long-term, equities are expected to outperform bonds. So, you would be selling equities to buy more bonds with rebalancing. That keeps your allocation steady and avoids the growing risk already illustrated in the chart shown above.

Over the long-term

You would be constantly decreasing the proportion of investments in your portfolio destined to be bigger winners to buy more of those destined to lag over the long-haul. Therefor, the averaged result would actually be a lower long-term return. Looking at the long-range chart below, the market goes through long periods of smooth upward trending (like 1975-2000) and choppy periods (like 1965-1975 or 2000-2015).

equities vs bonds growth

In the shorter-term

Volatility is higher over shorter time frames. If we hone in and compare a trending decade to a choppy “wild ride” one, we can see a monthly rebalancing strategy outperform or under-perform. Either way, the difference is small. Even more importantly, no one knows what type of market lies ahead.

rebalancing performance
rebalancing pros

You can cherry-pick different time frames to show different results. In addition to a trending versus volatile market in the periods that I highlighted above, another factor was at play. During the 1990s, bond prices and equity prices were positively correlated. Conversely, during the wild 2000s, they were inversely correlated. This means that they fluctuated in opposite directions, setting up a better rebalancing situation between equity and bonds during the 2000s.

Rebalancing may improve returns more for assets that have similar expected returns but are still only weakly correlated.

A good example of this are stocks or markets with similar risk/return profiles, but in totally unrelated sectors. They would be expected to have similar returns over the long-term. However, they would fluctuate and move differently in the short term.

With index ETF investing, it could be equity indexes that cover regions that have similar expected risk and return, but are influenced by different forces and perform differently over the short-term. The TSX and S&P 500 are a good example, as illustrated below over a 30 year period that encompasses both smooth and volatile markets.

rebalancing TSX with S&P 500

Rebalancing re-inforces disciplined investing.

As stated at the beginning of this post, the biggest reason to rebalance a portfolio is to manage risk. The biggest risk that rebalancing helps us with is the behavioral risk. The above historical models assume perfect investor behavior. In reality, investors usually lag those ideal returns due to fees, taxes, and bad behavior. The behavioral gap can average up to 2%/yr for investors as a whole with more volatile investments or market environments. Individually, it could be infinite if we make a big mistake. There are two ways that rebalancing helps manage behavior.

First, it helps to control volatility by keeping our equities from taking over as already illustrated. Volatility tickles the toes of our inner Hulk Investors. Unwise. Second, it enforces discipline to not try to time the market.

Market-timing is intuitively attractive but practically difficult. With our emotions in play – it is even worse.

Timing the market can be overt, like selling things that you think are about to drop with the plan to buy them back later for less (shorting the market). A bad idea for most DIY investors for many reasons beyond the scope of this article.

Market timing attempts can also be more subtle, like delaying a contribution and sitting on cash for the same reasons. “The market just made a new high. So, it is bound to drop soon (since it fluctuates) and I will buy then” is a common rationalization. I have definitely fallen victim to this one.

The problem is that rising markets will constantly be making new highs and it is impossible to know which one is going to be the last one before a drop. Markets rise more often than they fall over time, so the odds are not in your favor of picking a top. The path to the bottom in a declining market is also not a straight one, making picking the bottom difficult. Successful market-timing requires that you get both tops and bottoms right.

Rebalancing can combat our behavioral misdeeds by being simple and mechanical.

Mechanical rebalancing occurs when a pre-defined trigger is struck. When that rebalancing trigger is tripped, it must also be acted upon. That means that it needs to be a simple process. It also means that we should consider in advance what approach to rebalancing we want to use.

There are different triggers and methods to choose from. These must consider the benefits of rebalancing, as outlined in this post, against the potential downside of incurring extra transaction fees, burning time and brain cells, or triggering capital gains taxes. We’ll delve into that a bit further in the next post of this series.

14 comments

  1. Great article – 2 questions

    1) How do you balance across accounts? Do you ever find you have to add bonds to the corporate account or TFSA to achieve balance when this may not be ideal from a tax location point of view?

    2) When considering balance – how do you treat the eventual withdrawal taxes for the corporation/RRSP compared to the TFSA? Do you take into account how much the money will be taxed when it is eventually paid to you eventually or do you balance nominally and not even worry about the taxes on withdrawal? The implication of not worrying about taxes is that your balance may not be quite right when considering after tax dollars.

    Thanks!

    1. Hey Bari Doc. Two excellent questions.

      1) I will be covering the “how to” of rebalancing across accounts in posts 3 and 4 of this series. Also making a calculator that automates the process (has been a computer-coding nightmare, but making progress and learning a lot along the way). In short, when I rebalance, I consider the goals of my accounts and the goals of my holdings. Tax is only one aspect. This leads nicely to question 2.

      2) I don’t do post-tax allocation for my rebalancing. I will expand with a full future post why but my brief description. Firstly, it involves too much effort for me and the difference is usually not huge. The reason to do it is to have your risk after-tax reflect what you intend for your risk tolerance. If the reason to have tight risk-tolerance-adherence is because of low risk-capacity (you cannot financially afford volatility because you need the money in a specific time-frame with little wiggle room), then it could be important. If the main reason is behavioral risk-tolerance (volatility affecting your emotions and behavior but you will have more money than you need when you need it), then I think there is an advantage to NOT doing post-tax allocation. We naturally think in pre-tax terms when we see our portfolios (that is what shows up on our statements) which is what piques our behavior. So, we can trick ourselves into more risk (after-tax) and better returns long-term (after-tax) while seeing less volatility (pre-tax) by not adjusting if we build our portfolios with a goal-oriented approach to our accounts.

      I DO consider post-tax value when I define the goals for my accounts. The TFSA is after-tax and my goal is growth. My RRSP has a high tax-burden and could get unwieldy if huge – I want to put my lower-return safer investments (bonds) there. That shares my lower return with the government and I still get the emotional benefit. Eligible dividends flow well after-tax through a corp and capital gains work well there too. A personal taxable account is similar around capital gains and is after-tax when you take the money out. The Robocorp algorithm reflects these goals. In rebalancing (and the Robocorp Rebalancer I am making), I also try to adhere to this. Even above some tax efficiency. For example, it will avoid putting bonds in a TFSA unless a last resort – even if holding some in a tax-exposed account is slightly less tax efficient in the short-term. In the long-term, a large TFSA to draw from will save more tax upon accessing funds. I am playing the long game.

      I haven’t personally had to hold bonds outside my RRSP, but we have built pretty big RRSPs (22% of our portfolio) and the most I have targetted for bonds is 20%. I will likely need to later in life. Likely in our personal taxable account to keep income out of my corp as much as possible. Having different account types built over time is a major advantage in my opinion. Both for flexibility and to mitigate legislative risk. The main downside is complexity – but that can actually be made simple to execute with the online tools I have been working on.
      -LD

  2. Thanks loonie doc
    I can’t wait for your all encompassing world dominating tool.
    This is a great topic.
    Personally I think rebalancing is an unnecessary additional complexity in physician planning that only decreases returns. I think managing volatility and “risk” is not relevant unless you are within a few years of retirement. Volatility and risk are why we are fortunate to get/expect returns from investing in equities in the first place.
    I personally think a well diversified, tax efficient etf based portfolio, all equities without bonds or rebalancing until within 5 years of retirement is simplest, makes most sense, and optimizes returns long term.
    For docs we are immensely fortunate. Our job is our bond.
    I’m Probably overstating it, but that’s how I feel.

    1. Thanks Cowboy Cutter.

      I think that docs are fortunate in that our high incomes give us really good risk capacity. A lot of human capital to act like bonds from a safety net standpoint anyway. We can absorb temporary losses without it affecting our lives. We can even recover from some more permanent losses. However, I don’t think we are immune to emotions and behavioural mistakes though. I know people with large incomes and portfolios who talk of retirement or some big spends when the markets are rising and freak out when there is a decent correction. These are people used to performing logically under pressure in their jobs. It is almost comical, but it is human. Investor discipline is needed. Some can do that with all equity which would be the optimal return long-term, barring bad behaviour. Others needs some help via a barrier between them and doing dumb stuff (like an advisor) or bonds to take the edge off – both do come at a cost to returns.

      I definitely agree that we don’t need to be aggressively rebalancing frequently. It can actually be a drag on returns. Next week’s post shows some more data to back up that opinion. Regardless, on a practical level rebalancing for most people early on can be very simple – basically just buy more of what is lagging when you contribute. It doesn’t get more complicated until later when the portfolio is way bigger than the contributions.
      -LD

  3. Hi LD:

    thanks for your informative posts!

    If you rebalance in a corp account, you would likely decrease your small biz contribution amount. How much would that impact be?

    I am also not sure on how the limit is applied. Say you have 100K passive income which shields 250K. What if your net income is 300K? Does only the 50K (300-250) gets taxed on the higher rate, or do you lose the small biz rate on the full 250K?

    1. Hi John,

      Yes, rebalancing (if selling) could influence taxes. Half of the realized capital gains would count as passive income towards the combined active-passive small biz deduction. with your example of active income $300K and $100K passive income. On the $50K of active income over the SBD you would pay corp tax at the higher rate (~28%). NOT on the full active income ($300K). Also, that would give you the ability to give yourself eligible instead of ineligible dividends from the GRIP generated (72% of the $50K is about $36K eligible dividend). So, if you pay yourself $36K in dividends anyway – it actually not a big deal. About a 1% tax inefficiency from the tax integration when you factor the higher corp tax rate and the lower personal eligible dividend tax rate together. Those who don’t pay anything out of their corp would have a larger tax drag. The rules basically discourage letting a corp serve as an unlimited investing tax deferral vehicle without flowing money out (and paying tax on it). It still works great for that but is not unlimited in size anymore.

      As we move through this series, I will show that we can likely avoid or minimize that tax-triggering selling with some tweaks to when and how we rebalance. Tax loss selling can also help if there is an opportunity, but that is another topic.
      -LD

  4. I will tell you that you cannot underestimate the behavioral tendencies to not want to rebalance.

    I have believed in rebalancing from the get go but honestly my portfolio never got so out of whack that I needed to rebalance it till recently. And even though I knew I had preached it for awhile, it was tough selling an asset class that was killing it and taking that money and putting it into an asset class that was lagging behind (I still did it by the way but I could see how it just goes against your nature).

    I think rebalancing over the long run will smooth out the volatility of your overall portfolio and give you a better chance of gaining more in the end.

    1. Hey Xrayvsn,

      I agree about the behavioral difficulty and have had similar experiences. I think it is why we need a mechanical way to do it.

      I also think defining the triggers to rebalance and the process to use in advance to fit what you describe is key. My next post will examine triggers of both time and how out of whack matters – and what doesn’t. The brief answer is that less often and a less rigid is better. That removes most rebalancing tasks and stops us from cutting holdings with momentum behind them too short too early. Your gut was telling you that I suspect 😉

      I have only had to actually sell to rebalance once (some QQQ early last fall). It had disproportionately gotten way out of whack. It was a good move to stick to my plan. Successful behavioral follow-through requires making a plan that I understand, have researched enough to know it is good, and simple enough that I will follow it.
      -LD

  5. Thanks LD and Xrayvsn.
    I certainly can respect the behavioural risk, and I agree rebalancing in a pre-specified way would help to avoid some dumb decisions. I havent been through a massive correction/recession when I have also had a reasonable amount invested. Its easy for me to talk tough now.
    Thanks for working through all these important topics.

    1. Hey Cowboy Cutter. I actually think you are likely to be just fine in a downturn. You are thinking about financial capacity, human capital (like bonds) etc, and know the long-term perspective which all gives some resilience. Those who have that pre-thought-out are likely more resistant (although not immune).

      I also have high financial risk capacity, but added in 20% bonds in the fall because I could sense my risk tolerance as less than before. Largely because I had achieved FI and was a bit afraid of how I would respond if I were to see that temporarily disappear in a downturn. That said, I found myself fighting the urge to sell the bonds and go back to 100% equity around Christmas when the market had its really high volume down-day. Risk tolerance is really hard to assess and ever-changing.

      I am honestly still really thinking about where I sit personally and not sure where I will end up with it asset-allocation-wise. Probably on the aggressive end of the spectrum. The most recent correction bothered me much less than previous ones even though I had much more money on the table. I think it was due to having a much better understanding and more experience than I used to and having a more concrete long-term plan.
      -LD

  6. Thank you so much for your amazing articles and calculators – I’ve been exploring Robocorp for the last few days and it’s been invaluable!

    As a very new staff not yet incorporated and with ample TFSA and RRSP room, would it be reasonable to invest with my end asset LOCation in mind? For example, according to Robocorp my RRSP would hold 100% IEFA. I would invest all my extra income in this before moving to my TFSA which is 100% XEF. I know this means certain markets will be over-weighted and I’ll have no exposure to the US/Canadian market until I incorporate, but is that significant if I have a long investment window anyway?

    Thanks in advance.

    1. Hi HH,

      I actually just updated Robocorp last night. There is now an option for “not incorporated, but plan to.” I have also added the ability to select province which can make a difference for those who are not incorporated and don’t plan to be. The new high personal tax rates actually make US and EMM investment tax drag lower than the Canadian market in personal accounts in 8 of 10 provinces! Eligible dividends in a corp are still good. I did this so that it would dovetail with rebalancing later without selling equity from a personal tax-exposed account (if someone used them) as a corp rapidly builds up.

      In the interim, buying and selling within registered accounts is not a big deal since no tax triggered. I would just build up normally and then sell my US/Canadian in the registered accounts as I build up my corp later. Works quite nicely this way. My sequence would be fill up TFSA & pay off non-mortgage debt, then max out RRSP, then incorporate. I would just use my asset allocation of the time. Also, I would not buy/sell to make tiny adjustments. A 5-10% offside allocation is not a big deal – especially since it will rapidly disappear in the early days where the size of your contributions relative to the size of your accounts is large.
      -LD

  7. LD,

    Happen to be reading the Lord of the Rings trilogy with my son, and your “one rebalancing tool to rule them all” sounds most promising.

    Enjoyed your rationale and graphics, although the absence of mega violent comic book heroes seemed somewhat uncharacteristic..

    Fondly,

    CD

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