Why Rebalance Your Portfolio?

An important part of the indexing strategy is that you occasionally rebalance your portfolio back to its target asset allocation. I get a lot of questions about rebalancing, so I felt it was time to put together a series of posts about the idea.

For those who are new to the concept, we’ll start with a primer on what rebalancing is. One of the most important decisions investors will ever make is their asset allocation—the percentage of stocks, bonds, cash and other asset classes in their portfolio. For example, a mix of 60% stocks and 40% bonds is common in a balanced portfolio.

The problem is that asset allocations don’t stay constant. As the markets move month by month, your portfolio’s stock-bond mix will change, sometimes dramatically. If you had a 60-40 portfolio in mid-2008, the stock portion fell to about 45% by March 2009. If you were at 60-40 when the market bottomed, then your mix would be close to 80% equities today.

That’s why investors should occasionally adjust their portfolio to get it back to its target. You can do this by adding new money to the underperforming asset classes, or by selling off some of the outperforming funds and using the proceeds to prop up the laggards. In either case, the idea is to “reset” your portfolio to its original asset allocation.

Why rebalance?

One of the benefits of rebalancing is that it encourages you to buy low and sell high, so many people assume that the strategy is designed to boost returns. But that’s not actually the case. Think about it like this: if stocks outperform bonds over the long term—and we wouldn’t invest in stocks if we didn’t expect this—then a portfolio that is never rebalanced will naturally become more and more heavily weighted to equities. So more often than not, rebalancing will mean trimming back stocks and moving that money to the fixed income side. Over the long term, that’s likely to lower returns, not increase them.

If we assume an annualized return of 10% for stocks and 5% for bonds, then a portfolio that starts out with 60% in equities will naturally drift to 80% stocks after 20 years. Most investors do not want their portfolios to get more risky as they age. Rebalancing, then, is primarily about managing risk by keeping your asset allocation more or less consistent. If it does boost returns, that’s simply a bonus.

Another benefit of systematic rebalancing is that it helps investors control their behaviour. Whenever you add money to your portfolio, you need to make a decision about where to allocate those new funds. If you’re like most investors who simply follow their emotions, you’ll likely add the money to whatever asset class is hot. (How many people are enthusiastically adding to the bond side of their portfolios these days?) However, this is simply performance chasing, and over the long term, it’s disastrous. A disciplined rebalancing schedule—preferably written down in an investment policy statement—helps you avoid this trap and stay on course.

So how frequently should you rebalance your portfolio? There is no simple answer, but in my next post, I’ll look at some of the options.

64 Responses to Why Rebalance Your Portfolio?

  1. Donna December 19, 2016 at 12:10 pm #

    Hello. I recently asked Dan Solin (The Smartest Investment you’ll Ever Read) if there was a Canadian version of his US indexing strategies, and he kindly directed me to CCP-great site, and thanks to all for the info, as I am very new to DIY investing. I have about $70,000 to invest, with about 15 years before retirement.

    I’ve learned a lot reading the blogs, but there is so much info out there, and I’m not sure which steps to take or who to call first, to get the ball rolling.

    Can anyone offer a simple, uncomplicated strategy for investing this amount?

    Thanks so much!

  2. Canadian Couch Potato December 20, 2016 at 11:06 am #

    @Donna: Welcome to the blog. I’d suggest you look at my model portfolios and choose one of the first two options (Tangerine or e-Series):
    http://canadiancouchpotato.com/model-portfolios-2/

  3. Jose January 13, 2017 at 1:07 pm #

    Hi, just want to say thanks for this great blog and strategy. I’ve started using it as of last year (I’m a bit late but have a good chunk of money saved up) but I did have a question about the mix. In some online places, they mention that your stocks to bonds mix should be somewhere in the mix of bonds = your age and stocks = the difference. Is that still the case if you’re in your mid 40s?

  4. Canadian Couch Potato January 13, 2017 at 1:20 pm #

    @Jose: The “your age = bonds” rule of thumb is a fine place to start the discussion, but it’s not very helpful in the final decision. This post may help:
    http://canadiancouchpotato.com/2010/11/10/ready-willing-and-able-to-take-risk/

  5. sean shaw January 15, 2017 at 11:26 pm #

    Re-balancing schedule: Could you advise me as to the month of the year when re-balancing is most productive? I have been advised to re-balance my portfolio either on 1st. January or on 1st. July. Depending on the ups and downs in the market, would you suggest either of the above two dates or would any date would be o.k. provided I keep to this date every year for re-balancing?

    Thanks.

  6. Canadian Couch Potato January 16, 2017 at 11:45 am #

    @Sean: Your rebalancing schedule doesn’t need to be so strict. In a taxable account there might be some benefit to rebalancing (or not) on certain dates, but in an RRSP or TFSA it doesn’t matter, and it does not need to be the same date every year.

  7. Sherman January 23, 2017 at 2:10 am #

    Hi when I’m interesting in following Option 2 – When I make monthly contributions to my account, does that mean each time, I buy more of each fund? Ex. TD E-Series Fund 1,2,3,4?
    So if I have 25$ to put in monthly, do I divide it up to ensure that afterwards, each fund has the same balance as well?

  8. Canadian Couch Potato January 23, 2017 at 8:58 am #

    @Sherman: If you want to keep the portfolio in balance, you would add more money to asset classes that are below their target. But if the portfolio is relatively small you don’t have to worry about veering off target too much.

  9. Sherman January 24, 2017 at 12:14 am #

    Hi!
    Thanks for your reply. I’m not sure if I really understand what you mean. So every month, if I make a contribution of 1000$. I would add money to each fund in a way that keeps it in balance right?

    Or would I just equally divide that 1000$ into each asset class?

  10. Canadian Couch Potato January 24, 2017 at 7:24 am #

    @Sherman: It makes much more sense to add enough to each asset class to keep the portfolio in balance.

  11. Matty January 28, 2017 at 1:14 pm #

    I’m torn between buying VUN or VFN stocks via TD DI or Tangerine Index funds. You seem to favour Tangerine. I have 10k and want to invest it and am about to pull the trigger. Advice?

  12. Canadian Couch Potato January 28, 2017 at 2:08 pm #

    @Matty: It’s very difficult to cost-efficiently build an ETF portfolio with $10K. This article should help:
    http://www.moneysense.ca/save/investing/index-funds/ultimate-guide-couch-potato-portfolio/

  13. Charles Messier March 5, 2017 at 3:52 pm #

    Hi Dan ! In The MoneySense Guide, you say at page 288 that rebalancing with cashflow is “impractical to do this monthly if you use ETFs, as your transaction costs will be very high and they’ll overwhelm the benefits”. I’m wondering why because with Questrade, for example, buying ETFs is free. Is it because it wasn’t free in 2013 when you wrote the book ?

  14. Canadian Couch Potato March 5, 2017 at 4:37 pm #

    @Charles: Only a small number of investors use Questrade so I can’t assume that everyone can trade ETFs for free. But if you pay no commissions, then sure, you can add new money monthly.

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