A term you have likely heard tossed around in the financial services world is ‘rebalancing’. Economist John Maynard Keynes said, “The market can remain irrational longer than you can remain solvent.” With this major concern in the background, let’s define rebalancing as the action which brings something back into balance.

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What is Rebalancing?

To keep the concept simple, let’s assume we have a portfolio consisting of 2 assets. We will call them ‘Stocks’ & ‘Bonds.’ To further simplify the concept, we will assume an equal investment into these two positions. I would often describe this portfolio as a 50/50 portfolio.
Over time, one position of the portfolio could become greater than the other due to market increases or market decreases. The act of rebalancing is simply returning the portfolio to its original position (50/50 allocation).balance changing over time

why do we rebalance
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Why Do We Rebalance?

The simple answer is we rebalance to keep the risk of the portfolio in alignment with the original allocation. Notably, often investment returns may be enhanced.
If we sell that position which has gained in value (the position that is up) and buy the position which has decreased in value (the position that is down) then we could potentially be selling high and buying low. We call this a sell-high-buy-low opportunity. The idea being that the position which we have just purchased at a lower price has the potential for more upside growth than a position which has recently increased in value.
Notably, this sell-high-buy-low opportunity would assume that we are buying assets which do not move at the same speed and in the same direction. To simplify the conversation, lets now assume we have 50% of the portfolio in stocks and 50% of the portfolio in bonds. Because stocks have higher returns over time, the 50% of stocks would grow at a far greater rate than the bonds causing the stocks to account for more of the value of the portfolio than the bonds.

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The Problem with Rebalancing

Here is the bad news of rebalancing between stocks and bonds. Over time, you end up selling more of the assets which perform greater and buying assets which don’t perform as well. However, if we don’t rebalance, then the portfolio will end up being much more aggressive than the tolerance of many investors. I really do not want ‘granny’ having 80% of her portfolio in stocks and 20% of her portfolio in bonds.

economic benefits of rebalancing
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On the other hand, research shows that rebalancing between similar asset classes could increase potential returns; rebalancing between a large-cap stock and a small-cap stock (which historically outperforms large-caps), for example. However, as we discussed before, the risk of the portfolio increases if we do not rebalance the portfolio back to its original allocation as small cap stocks carry more risk than large cap stocks.

How Often Should We Rebalance?

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In many of our 401(k) and 403(b) accounts, an “automatic rebalance” feature automatically rebalances portfolio assets every month, quarter or year. However, research shows that there is very little difference in results between monthly or annual rebalancing. In fact, as we mentioned earlier, rebalancing monthly or annually actually could reduce returns by an average of 0.50 - 0.60% over never rebalancing.

Enter Tolerance Band Rebalance

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At this point, you may be asking, “Is there a way to rebalance my portfolio so that my risk doesn’t increase and without sacrificing my returns?” Enter Tolerance Band Rebalancing! Studies have confirmed that rebalancing based on a calendar date have resulted in decreased returns when compared to a buy and hold strategy. However, target-band rebalancing actually provides a 0.38% greater return than even the buy-and-hold strategy, and almost a full 1% greater return than systematic rebalancing strategies.

finding optimal tolerance bands
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What is A Target-Band?

A diversified portfolio will have various positions moving in different directions at different speeds. Meaning, one position could have an increase of 10% while another position could have an increase of 2%, still yet another could have a decrease of 7%. Each of these positions moving intraday toward a gain or a loss. A Target-Band sets the percentage an asset within the portfolio is allowed to travel before a sale is triggered. When any position drifts outside of the target-band, a buy/sell transaction in that position is triggered.

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What Percent Should the Target-Band Be?

Research provides us quantified, tested data showing that the optimal target-band should be set at 20%. Research further illustrates that the rebalancing occurring in 1-day, 5-day, or 10-day increments provide an even greater return. As the chart above illustrates, we realize a net portfolio increase of 0.38% through the use of target-band rebalancing.

What About Contributions and Withdraws?

There is a big secret in investing… buy low and sell high! Keeping in-step with this philosophy, when you deposit dollars into your account, you want to buy the position in the account that is under-performing. Yep, you want to buy the dog! You want to invest in the position that is performing the worst. You may be saying, “Justin, this doesn’t make sense.” Actually, it does! You want to buy low. Think of it like this –you are getting that asset “on sale!” If you were to buy the best performing asset you would be buying high (or paying a premium). This is not the best move.

tolerance vs time interval rebalancing
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Contrarily, when you are withdrawing money from the account, you want to sell the position which is performing the best. In doing so, you will be selling “high.”

Summary

The simple graph above, shared by Michael Kites, shows the results of Target-Band rebalancing over annual rebalancing. Our goal is to maximize the returns of your portfolio within your respective risk tolerance.

Application for You

Our goal is to grow your portfolio. Technology now allows for daily monitoring and the efficient application of target-band rebalancing, which we employ here at Heritage Investors, LLC. Research suggests that by using target-band rebalancing over traditional rebalancing techniques, we could even offset the advisory fees with the gains realized (as much as 1%)! We have not experienced much market volatility in the past decade and those days are quickly falling away. You may see more trades in your accounts as we work to hold the risk tolerances in these turbulent times.

If you have any questions, please let us know.