When and how to rebalance your portfolio

On a regular basis, my clients ask me whether it is really necessary for them to rebalance their portfolios. 

I normally use the theory of displacement (the simple version) to explain to them why it is done. If an object is placed into a container filled with water, the water level will rise, because the object is taking up some of the water’s space by pushing it away. 

As soon as the object is removed from the water, it will drop back to its original level. The important thing, of course, based on this analogy, is finding the water level you are most comfortable with.

The primary objective of rebalancing a portfolio is to reduce risk through target asset allocation, not necessarily to increase returns. 

The various asset classes move in different ways, much like the water being displaced, and depending on the size of the “objects” or market events that have an effect on these levels, your asset allocation in each asset class will likely change over time because of these movements.

Unfortunately, rebalancing isn’t free, so what should you consider before doing it and which method is the best?

First, any sales done within your portfolio will trigger a tax event (short-term trading will result in income tax implications, while long-term trading will have capital gains tax implications). 

Second, there will always be transaction costs attached to sales and purchases. 

There are three main rebalancing methods: time-based, threshold-based and a combination of these two. The time-based method means that you will rebalance your portfolio on a fixed regular basis. 

Let’s suggest that your original portfolio consisted of a 60% allocation to local shares and a 40% allocation to local bonds. 

Following a time-based method, you will then rebalance your portfolio on a monthly, quarterly or annual basis to restore it to its original 60/40 levels.

The threshold-based method may give an investor a little more freedom to (hopefully) rebalance their portfolio less frequently. 

According to this method, rebalancing is only done once the portfolio exceeds a particular threshold. 

By using the same example as above and applying a 10% threshold, it means that the investor will only rebalance once the original allocation of 60% in shares, rises above 70%.

As a third alternative, investors may choose to apply a combination of these two methods by still monitoring their portfolio weights on a fixed regular basis, but only rebalancing it if it exceeds the predetermined threshold at that time. 

To take the discussion on rebalancing a bit further, I decided to try and determine whether regular rebalancing adds any real value to your portfolio. The answer: not really. 

The data we used over the last 20-year period revealed that if you had a portfolio that consisted of 60% local shares and 40% local bonds at the start of this period and you made no changes over the entire 20-year period, your annual returns before costs would have totalled 15.32% with an annual volatility ratio of 11.77%. 

If you followed the time-based method and rebalanced on a monthly basis to restore the original 60/40 allocations, your returns before costs and excluding all taxes, would have totalled 15.24% with a slightly lower volatility ratio of 10.66%. 

Quarterly rebalancing would have resulted in 15.29% returns and a volatility ratio of 10.63%, while annual rebalancing would have resulted in 15.32% returns and a volatility ratio of 10.62%, both also excluding all costs and taxes. 

Even the combined time-threshold method (with a threshold of 10%) didn’t really make a huge difference, delivering returns and volatility ratios (before all costs and taxes) relatively close to those delivered by following the passive method. 

Don’t get me wrong – I’m not saying that rebalancing should be avoided in your portfolio, because asset allocation remains extremely important in the management of your investment portfolio within your risk profile. 

You should, however, be careful of switching between the different asset classes too often, because the costs and taxes attached to rebalancing too often may have a negative effect on your total portfolio returns. 

Make sure that it really adds value to your portfolio when you do rebalance. 

Schalk Louw is a portfolio manager at PSG Wealth.

This article originally appeared in the 24 May edition of finweek. Buy and download the magazine here, or sign up for our weekly newsletter here.