I’ve talked before about how important it is to rebalance your investment portfolio. And while it’s important to understand the concept of rebalancing, we need something more practical. We need to know when we should rebalance our investment portfolio. That way we can put this strategy into practice the right way at the right time.
Rebalance your investment portfolio: From idea to action…
Once you embrace index fund investing, there are a few basic steps that will lead you from idea to action:
- Determine your asset allocation
- Buy funds according to your asset allocation
- Rebalance your asset allocation
Let’s go over each of these steps…
1. Determine your asset allocation
Step #1 is where most people get hung up.
First, what percentage of stocks and bonds?
A good starting point is your age (rounded to nearest 10) minus 10 for your bond percentage. I’m 37 so that would mean 30% bonds.
Now, think if you would like to be more or less aggressive. The further into the future that you are planning to need your money, the more aggressive you may generally be.
If you’re more aggressive, do less bonds. Less aggressive? Do more bonds. This is defined by your personal risk tolerance.
You can learn more about bond allocation in this post, Bonds Asset Allocation: What Should Yours Be?
So, in this simplified case, our asset allocation is 70% stocks and 30% bonds.
2. Buy funds according to your asset allocation
Now, we take the sum of money that we are planning to invest. Let’s say it is $100,000. Through simple math, we know that we are planning to invest:
- $70,000 in a Total U.S. Stock Index Fund (70% * $100,000 = $70,000)
- $30,000 in a U.S. Total Bond Market Fund (30% * $100,000 = $30,000)
Note this is a very simplified example. In your actual asset allocation you will likely want to split your stock (international, small value tilt, etc.) and bond investments (TIPS, etc.) up to some degree.
3. Asset allocation and rebalancing according to a set schedule
Ok, so now you have determined your asset allocation and bought funds according to your asset allocation. What next?
When investing in anything, the goal is to buy low and sell high. Then you earn the difference between the buying price and the selling price.
But how can you do this in the market without timing it or guessing the future, which we cannot reliably do?
It’s actually incredibly simple.
After you buy your funds in your asset allocation, do nothing. Then, rebalance your investment portfolio back to your goal asset allocation.
Here’s an example of how to do this:
Some years, stocks will do better than bonds.
At the end of the year using our example, you may have 80% stocks and 20% bonds from our original allocation of 70% stocks and 30% bonds (because stocks performed better).
To rebalance, you would sell enough stocks (you are selling high) and buy enough bonds (you are buying low) to get an allocation back at 70% stocks and 30% bonds. Alternatively, if you are investing more cash into your investment portfolio, you can just rebalance by buying enough of each asset to get back to your goal percentages.
Do this and you are guaranteed to ALWAYS sell high and buy low. That is why rebalancing works and has been shown to provide greater returns over the long run. It also keeps your portfolio risk aligned with your risk tolerance so you don’t panic and sell in a down market.
But when should you rebalance your investment portfolio?
This is where the rubber meets the road. Because you shouldn’t rebalance anytime the market swings one way or the other. You would end up incurring too many fees and taxes that any potential increased returns would be more than nullified.
So, what are we to do?
Well, I think Larry Swedroe is a pretty smart guy. Here’s his rule of thumb.
The 5/25 percent rule
Simply put, the 5/256 percent rule says that you should rebalance your investment portfolio only when a particular asset class’s allocation changes by either an absolute 5% or 25% of its target allocation.
Let’s illustrate with an example…
My earlier example asset allocation was 70% stocks and 30% bonds. The 5/25 percent rule says that I should rebalance when either allocation veers from its goal by either an absolute 5% or a relative 25% for its goal allocation.
For our stock allocation of 70%, this means we should rebalance whenever it reaches the lesser of:
- 65% or 75% (70% +/- 5%), or
- 52.5% or 87.5% (70% +/- 17.5% [25%*70%])
In this case, the 5% portion of the rule would prevail and I would rebalance at those parameters only.
For our bond allocation of 30%, we would rebalance when the allocation reaches the lesser distribution of:
- 25% or 35%, or
- 40% or 50%
Again, the 5% portion resigns supreme in this example. But that is not always the case. If our bond allocation was 10%, the 25% range would be more narrow and would dictate our rebalancing strategy (with a delta of 2.5% compared to the absolute 5%).
What gets rebalanced?
This is an important point and source of confusion. Again, the asset allocation example I used was super simplistic on purpose. In reality we may have an investment portfolio like this:
- 25% total US stock market index fund
- 25% total international stock market index fund
- 20% US small value index funds
- 10% total bond market fund
- 10% TIPS bond fund
In this case, we need to be mindful to rebalance based on the 5/25 percent rule on 3 levels:
- The overall stock/bond allocation level (70%/30% in this example),
- The domestic/international allocation level (45%/25% in this example), and
- The more narrowly defined asset allocation (like total bonds and TIPs, etc in this example)
If you need to rebalance the overall stock/bond allocation and, let’s say, needed to increase your stock allocation, you could decide to do so in a manner that gets your stock subsets back in alignment with their goal allocation as well.
Some quick rebalancing caveats
- In the accumulation phase of your investing career, you will likely rebalance more by just adding additional cash to particular asset subsets until your goal allocation is reached.
- In the withdrawal phase of your investing career, you will withdraw from overachieving funds first such that you rebalance back to your goal allocation (this also ensures that you sell when future expected returns are lowest, because valuations are already high in this asset class).
- You should avoid selling assets that will incur a short term capital gain tax for rebalancing purposes. Just wait until you reach the point of hiding the assets for at least 1 year to avoid this.
- If rebalancing will incur large long term capital gains taxes, consider rebalancing just to the minimum parameters rather than back to the absolute goal allocation number.
Putting it all together
The strategy of rebalancing your portfolio is pretty straightforward in today’s day and age, thankfully.
Any online brokerage portal should be able to show you very specifically your exact asset allocation at any moment. At most, you may have to average your percentages across various accounts. But there are plenty of software programs where you can add all investment accounts together to get the overall allocation shown.
Further, most brokerages also allow you to see how any change in investments, whether by buying and selling current funds or adding new cash to your portfolio, will affect your allocation percentages.
That makes the 5/25 percent rule really easy to implement.
How I rebalance my investment portfolio
Here’s how I do it…
Every January, I go through my accounts and rebalance back to my asset allocation. And you can see my allocation and entire portfolio here.
Why do I rebalance just once a year? Well, at this point it would take a pretty big swing in the market to meet the criteria for rebalancing according to the 5/25 percent rule. However, as my assets grow, less and less of a swing will be necessary to throw things out of whack.
And at that point, I plan to abide by the 5/25 percent rule!
For more practical investing strategies to reach financial freedom, check out these posts:
- How Much International Stock Should Be in Your Portfolio?
- Evaluating the Two Funds for Life Portfolio for Doctors
- How Much Is Enough Retirement Savings?
- When Should Doctors Take Social Security?
- How Doctors Can Calculate Their Expected Net Worth
What do you think? How do you rebalance? What rules of thumb do you use? Have you tired the 5/25 percent rule? Let me know in the comments below!
