How I Rebalanced Through Perilous Times

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“Benign neglect, bordering on sloth, remains the hallmark of our investment process." —Warren Buffett

To rebalance, or not to rebalance? When? How? We’ve reviewed the sometimes conflicting and arbitrary advice of a number of experts. We’ve found a vague consensus in favor of rebalancing, but we’ve also seen studies by respected voices questioning whether rebalancing adds enough value to bother.

Now I’d like to show you my own personal rules for rebalancing. They don’t require any tricky calculations, careful scheduling, or complex transactions. When in doubt they prescribe simplicity or "doing nothing" over complexity or active management. What they may lack in precision or certainty, they make up for in safety and ease of use. These are the same rules I used to grow my portfolio and retire at age 50 with security and confidence. Let’s take a look:

1. Don’t rebalance more frequently than annually, and consider waiting several years. Consider never rebalancing in your taxable accounts.

Research points to an ideal rebalancing interval of several years, if at all. By thinking in terms of those longer time frames, you remove some risk that you will act emotionally, in response to shorter term market movements. Of course you still must choose the exact moment to rebalance, and that’s a decision that will always be subject to emotion. So, if you decide never to rebalance, it’s good to know there is ample evidence and authority to be confident about inaction, especially in taxable accounts.

2. Don’t worry about "small" changes in your asset allocation, where "small" means at least 10% and possibly even more in your overall allocation.

Some of the most seasoned and respected experts recommend rebalancing only after very large changes in value, or not at all. So there is no hurry. Be especially cautious about rebalancing in response to short term market movements, or during times of high volatility. You may find yourself rebalancing again before long, racking up more transaction costs and taxable gains in the process.

3. Do most of your rebalancing during the course of adding new money, taking withdrawals, or reinvesting distributions, by buying laggards or selling winners.

Leveraging the natural inflows and outflows for your accounts, rather than explicitly buying and selling shares, saves you from several investing pitfalls, including trying to time the market, incurring additional expenses, and generating taxable gains.

“Buy low, sell high.” In my personal experience, the savvy investing behavior that is easiest to adopt is buying what’s cheap, as new money becomes available for you to invest over time. It tends to be easier, and more reliable, to identify and buy what’s clearly on sale now, than it is to predict if and when it’s time to sell your winners.

4. But when an investment, especially an individual stock, sector, or asset class, has delivered 2-3 years of double-digit returns, expect it will revert to the mean (or beyond), and sell some if you want.

It’s an unfortunate fact of investing that, for all but the simplest of portfolios, you must remain alert to bubbles, whether they be dot-com, real estate, commodities, or something else. Don’t completely ignore volatile asset classes for years at a time, or assume that 20% returns in one investment will go on forever. They won’t.

My biggest investing mistakes were not selling hugely successful and over weighted positions which later reverted to more average values. I would have done much better if I’d had the humility to sell when I was way ahead. But I lived to tell the tale, and so will you — if you don’t fall into the trap of throwing more money at those positions late in the game.

5. As with choosing your individual investment holdings, consider diversifying your rebalancing strategies — the" when," the "how," and the "if."

Don’t rebalance all at once. It’s not possible to pick the optimal date for rebalancing: so spread out the risk. Rebalance in modest chunks spread over longer time intervals.

Consider owning some investments that rebalance automatically on their own schedule. This is one area where I see value in some professional management — ideally via a low-cost "balanced" fund that automatically rebalances to some target asset allocation on a regular basis. A professional manager guided by a clear asset allocation strategy, such as "60% to 65% of assets in common stocks and 35% to 40% of assets in investment-grade bonds," goes to work every day to monitor and implement that strategy, in the most cost effective way possible. Just be certain that the expenses charged for this service are razor thin, as they should be. It’s a valuable service, but it’s not active management.

Even though I’ve managed a large portfolio for years, investing is not my full time job, nor even my main interest. I simply don’t expect to find the “perfect” rebalancing formula across my entire portfolio on a continuous basis over the long haul. That’s why Vanguard Wellesley Income, a conservative balanced fund, has been my largest holding for years. (If I had it to do over now, I might choose Vanguard’s Balanced Index Fund or LifeStrategy Moderate Growth Fund instead, both passively managed.)

It is well worth the small fee that Vanguard charges (0.18% in my case) to hire a full-time manager to implement a consistent rebalancing policy, as part of my overall rebalancing effort.

In conclusion, assuming you began with a diversified portfolio, don’t fear inaction. You’ll sidestep a number of potential investing blunders that way. The majority of my own rebalancing strategy, as recommended by experts including the legendary Warren Buffett, is characterized by "benign neglect, bordering on sloth."

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