Rebalancing plays a crucial role in ongoing portfolio management, both to ensure that the overall risk profile of the portfolio doesn’t drift higher (as equities tend to out-compound bonds over the long run), and to potentially take advantage of sell-high buy-low opportunities in a methodical way.

The problem is that there seems to be a lot of confusion and misinformation floating around as to how often a portfolio should be rebalanced in order to achieve these goals.

The conventional practice of many investment firms is to rebalance a portfolio at least once per year, and possibly even more frequently, such as quarterly or monthly.

A deeper look, however, reveals that more frequent rebalancing will on average have little impact on risk reduction, even less benefit from a return perspective, and may rack up unnecessary transaction costs along the way.

A study from Vanguard, by Jaconetti, Kinniry and Zilbering, found little material difference in outcomes for rebalancing frequencies varying from monthly to annual, once measured on a rolling period basis.

When analyzed using a 60/40 portfolio going back to 1926, the researchers found that rebalancing quarterly or monthly produced no improvement in long-term risk or returns; it simply drove up the turnover rate, the number of rebalancing events, and potential transaction costs. (1)

Instead, a superior rebalancing methodology might be to allow portfolio allocations to drift slightly and trigger a rebalancing trade only when a target threshold is reached.

This is the concept behind Tolerance Band rebalancing, meaning if the investment holdings grow in line and the relative weightings don’t change, no rebalancing trade occurs.

However, if these “tolerance bands” are breached, the position – and only that position – that crosses the line, is then bought or sold to bring it back within the bands.

The one caveat to the process of tolerance band rebalancing is that it requires ongoing active monitoring of the portfolio itself to ensure that you know when a threshold has been reached. We have systems to automate this.

Still, we need to determine what the rebalancing bands should be in the first place – how much of a relative movement is appropriate to trigger a trade?

As with any allocation band (or any other rebalancing) approach, the key here is to set the threshold wide enough that it won’t trigger an excessive volume of trades (which racks up transaction costs) or repeatedly curtail positive momentum (or amplify a crash), but not to set the thresholds so wide that any rebalancing opportunities are lost because no trades are triggered at all.

Evidence suggests that the optimal rebalancing trigger was at a relative threshold of 20% of the investment’s original weighting.

Setting the thresholds narrower, such as only 10% or 15% bands, produced less favorable results, as did rebalancing bands that were 25%. (2)

The goal, again, is to set a threshold that is ‘far enough’ out to allow investments to capitalize on momentum, but not so far that they run to extremes and bounce back again, without ever triggering a buy or sell trade.

We’re not trying to reinvent the wheel, but to curate the very best research around rebalancing.

Much of the above is credited to the following Sources:

Kitces, M. (2017). Best Opportunistic Rebalancing Frequency

1. Jaconetti, Kinniry and Zilbering. Vanguard. Best Practices for Portfolio Rebalancing Report

2. Daryanani, G. (2008). Gross Annualized Arithmetic Average Returns

Swedrow, L. (2014). Portfolio Rebalancing: The Whys and The Hows