Pick up any mainstream personal finance publication and you’ll read about the benefits of passive or buy-and-hold investing — putting your assets in a few low-cost index funds or exchange traded funds (ETFs) that will capture market returns with less risk and expense over the long haul. It sounds like the easy, automated route to investing success. And it can be. Yet rebalancing — periodically adjusting your asset allocation towards some predefined target — may be the weak link in passive investing.
There is no real consensus on when or how to do rebalancing, or even if to do it at all. The venerable John C. Bogle, founder of Vanguard, concludes at least one discussion with “Rebalancing is a personal choice, not a choice that statistics can validate.” (See Ask Jack.) The few experts that discuss rebalancing at any great length rarely give a specific strategy or system, backed up by logic or data, for actually implementing it. And, when there is no system in place, rebalancing can become the smoke screen for a wide array of market-timing, wealth-deflating maneuvers.
While rebalancing may be good in theory, ask yourself how well you can standardize something you do only once a year, or less. (Most authorities recommend rebalancing at most annually, and probably less often.) If you do your own taxes each year, you’re familiar with the pain of trying to remember how you handled, say, equipment depreciation or the foreign tax credit, a year ago. Or how about those home maintenance chores like removing storm windows, draining the water heater, or vacuuming the fridge coils, that experts say you should do annually? Do you remember an exact procedure for those, or do you wind up partly reinventing the wheel each time, if you do them at all? It’s the same with rebalancing.
An even more serious issue, over longer time frames, is that your risk/return goals are probably a moving target. Even the most savvy and experienced investor is likely to see their risk tolerance and subsequent target asset allocation change over a period of years. Think of how the world changes, and how you change, often dramatically, in the course of the average year — not to mention several years. Was your tolerance for risk really the same in the 1990’s as it was in the 2000’s? What have you learned since then? What life changes have you experienced — jobs, moves, births/deaths, expenses, inheritances, health issues? Each of these, along with your natural aging, will impact your views on the risk/return equation, and thus your preferred asset allocation.
In sum, rebalancing may just be the Achilles’ heel of passive investing. Ignored, it threatens to increase your risk and change your returns; done incorrectly, it casts you as a market timer, with both higher costs and the risk that you’ll underperform the market.
I don’t have a magic solution, but I do have some personal rules of thumb for rebalancing. These are the same rules I used to grow my portfolio and retire at age 50 with security and confidence. For more details on the when, how, and if of rebalancing, stay tuned. And if you have your own rebalancing rules or tips, please add them below!