With stocks continuing to enjoy a roaring bull market, rebalancing is on the minds of many investors—or at least it should be. Disciplined investing starts with choosing long-term targets for the asset classes in your portfolio and making regular adjustments to stay on course. Rebalancing discourages you from chasing performance, timing the markets and taking inappropriate risk.

There are three main rebalancing strategies. The first is based on the calendar: you might rebalance annually, or even several times per year. (Many balanced funds, for example, rebalance every quarter.) The second is based on thresholds: a rebalance might be triggered any time an asset class is five percentage points off its target. Finally, you can rebalance with cash flows, buying underweight asset classes with new contributions or cash from distributions (or, if you’re drawing down your portfolio, selling overweight positions when you make withdrawals).

In the real world, most investors probably do some combination of all three, and that’s fine. But there’s a good argument to be made for emphasizing the cash-flow method.

Go with the flow

Rebalancing with cash flows is particularly useful for those making regular contributions. The idea is that you deposit cash in your account every month or so, but you don’t invest it immediately (you might use an investment savings account to earn a little interest). You also take all your ETF distributions in cash rather than setting up dividend reinvestment plans (DRIPs). The money accumulates until you have enough to make a single cost-effective trade: then you use it to buy whichever asset class is furthest below its target. If you’re paying commissions to trade ETFs, you should wait until you have enough to make a cost-effective transaction. (This is less of an issue if you use mutual funds or commission-free ETFs.)

A rebalancing strategy based on cash flows has several benefits:

  • Fewer transactions. Calendar or threshold rebalancing typically involves both selling and buying. But rebalancing with cash inflows requires only purchases, which can reduce the number of transactions. (You may still need to sell an overweight asset class during a dramatic market move.) And as long as you keep the cash balance under 2% or so, the drag caused by holding too much uninvested cash will be negligible.
  • Easier decisions. There’s lots of evidence that investors find selling harder than buying. We shouldn’t underestimate the discipline it takes to put your money into assets that have recently fallen in price (did you buy real-return bonds last year?), but experienced investors will likely find it easier to buy low than to sell high.
  • Lower taxes. In a non-registered account, selling overweight asset classes is likely to result in realized capital gains. Rebalancing with cash inflows allows you to keep selling to a minimum and defer those taxes longer.
  • Easier to track adjusted cost base. While reinvesting distributions is an effective way to benefit from compounding, it can cause headaches in non-registered accounts. With many ETFs now paying dividends monthly, you’ll need to adjust the cost base of your funds for an additional 12 transactions per year. By taking the dividends in cash you’ll reduce that burden.

Pick one and stick with it

Rebalancing with cash flows may have practical benefits, but how does it compare in terms of performance and risk management? Remarkably well, it turns out. A Vanguard study in 2010 compared various rebalancing methods using targets of 60% stocks and 40% bonds, with data going back to 1926. The researchers found surprisingly modest differences in the long-term results. As long as you chose a reasonable strategy and stuck to it, the annualized returns and volatility were similar.

For example, a portfolio rebalanced every month had an annualized return of 8.5% and a standard deviation of 12.1%. If the rebalancing was planned annually but only performed if the portfolio was more than five percentage points off target on the scheduled date, then the annualized return was 8.6% and the volatility was 11.8%. Finally, if the portfolio was simply rebalanced by reinvesting all the dividends and interest in the underweight asset classes, the return was 8.5% and the volatility 11.3%.

Moreover, the study ignored transaction costs and taxes: had these been included, the cash-flow method would almost certainly have come out ahead. As the Vanguard researchers wrote: “An investor who had simply redirected his or her portfolio’s income would have achieved most of the risk-control benefits of more labor- and transaction-intensive rebalancing strategies at a much lower cost.”