Invest Like the Best: The Zen of Rebalancing

What is Rebalancing?

Once you decide on a portfolio target allocation (e.g., the Canadian Couch PotatoBalanced” allocation of 40% ZAG Bond Index, 20% VCN Canadian Index, and 40% XAW World Index – see more here) and purchase your securities, you’ll notice over time that your chosen allocation will slowly drift away from these starting points.  For example, let’s say you initially chose to invest a total of $100,000 in the above allocation mix, resulting in $40,000 of ZAG, $20,000 of VCN, and $40,000 of XAW.  In a bull market, after a year you might see your gains in VCN & XAW outpace those of ZAG like this: VCN grows to a value of $25,000, XAW grows to a value of $50,000, and ZAG grows to a value of $41,000 for a total portfolio value of $116,000 over the course of a year.  Your resulting allocation has now changed to ZAG: 35.3% ($41,000/$116,000), VCN: 21.6% ($25,000/$116,000), and XAW: 43.1% ($50,000/$116,000).  As such, the risk in your portfolio has effectively increased as your percentage of bond holdings has decreased from 40% to 35.3%.  If this is something that makes you uncomfortable, you should fix it.

Rebalancing means buying and/or selling portions of the above securities so that the relative percentages of each return to your goal allocation.  So, assuming that you weren’t going to add or subtract from your portfolio, for the above example, your rebalanced allocation would look like this:

ZAG (40%) = $46,400 (i.e., need to buy $5,400 ZAG)

VCN (20%) = $23,200 (i.e., need to sell $1,800 VCN)

XAW (40%) = $46,400 (i.e., need to sell $3,800 XAW)

Just go ahead and do those and you’re done for another year.

NB: If you’re planning on using the proceeds from selling securities to buy others, (e.g., as in the above example, selling VCN & XAW to buy ZAG), the process necessarily will take several days to complete as you’ll need to wait for the sale transactions to “settle” before the money is available for a purchase.  I don’t really do things this way as I’m always adding new money to my portfolio.  Consequently, instead of selling a security, I just end up buying more of the others to achieve my target percentage allocation – see below for an example.

Buy why do this?  Let’s look at the rationale for rebalancing….


Why Rebalance Your Portfolio?

One thing that rebalancing does is forces you to buy low and sell high.  In other words, any time a particular security outperforms the others, the relative percentage it represents in your portfolio goes up.  Selling some of this and putting that money into the laggard(s) forces you to lock in that gain and buy more of the lower one(s) in preparation for a rebound.

So, does that mean that rebalancing boosts your returns?  Over the long term, it quite likely will. Rebalancing lowers the impact of bear markets on your portfolio because it forces you to take money out of stocks and put it into bonds over the course of a bull market.

But the real reason for rebalancing your portfolio, as I alluded to above, is to manage risk.


Rebalancing Strategies

Dan Bortolotti wrote a nice article on this over at his CCP website.  I’ll hit the high points here.

There are 2 main rebalancing strategies (I use both):

1. According to a Timeline:  For instance, annually. I rebalance my portfolio at the beginning of each new year, to keep things consistent (it probably doesn’t matter much when you choose to do it, though).  My method for this is similar to the above example but I pretty much always have new money to invest as well.  This is because, for the previous 12 months, I’ve been contributing a regular monthly dollar amount to my account that I keep in cash (this is automated so I don’t even have to think about it).  I just add this amount to my portfolio’s current value and then figure out my target dollar amounts for each of the securities.  So, continuing with the above example, if I saved $3,000 per month for the past year, my portfolio’s new value would be $36,000 + $116,000 = $152,000.  This would mean my target dollar value for each of the 3 holdings would become:

ZAG (40%) = $60,800 (i.e., need to buy $19,800 of ZAG)

VCN (20%) = $30,400 (i.e., need to buy $5,400 of VCN)

XAW (40%) = $60,800 (i.e., need to buy $10,800 of XAW)

2. According to a Threshold: For instance, any time one of your holdings deviates from its target percentage by, say, 2% or more.  I do this one too.  While I have said that I don’t watch the markets much at all, I do check on them very briefly from time-to-time throughout the year as this is pretty much the only “market timing” strategy that has been shown to reliably pay off. If it looks like the market has fallen by a significant amount, I tend to use that opportunity to buy some stock ETFs (i.e., VCN and/or XAW) with the money I have accumulated to date in cash through the automated, regular contributions that I’ve been making every month.  Alternatively, if the markets have been rising, I can also use that opportunity to buy some of my bond ETF (i.e., ZAG) if its percentage representation within the portfolio has dropped to 38% or below.

NB: ETFs also tend to pay cash dividends on a regular basis (e.g., quarterly).  You can choose to have these automatically reinvested in the ETF via a Dividend Reinvestment Plan (DRiP) or just deposited into your investment account in cash.  If you choose the cash option, then you can use that money for rebalancing along with the regular contributions you make throughout the year.


So What’s the Best Strategy?

According to a 2010 Vanguard Study, it really doesn’t matter.  The differences are so small that it’s not worth wasting any neurons on the details.  Just pick a strategy (or both) and stick to the plan and you’ll be taking a big step in effectively managing the risk in your portfolio (and very likely boosting your returns at the same time).


Action Steps (30-60 minutes per year)

  1. Automate your Savings: If you haven’t done it already, set up an automated monthly cash contribution from your earnings account to your investment account.
  2. Rebalance Now: Go to your investment account and take a look at the current market values of each security.  Using one of the methods above, figure out what you need to do (i.e., buy or sell each one) to rebalance your relative percentages and do it.
  3. Rinse & Repeat: Mark your calendar for one year from today, when you’ll rebalance again.


BONUS: check in on the market trends once per quarter and compare your portfolio’s current market value mix to your target allocation.  Rebalance as necessary.


What do you think about the rebalancing strategy for a Canadian MDs’ portfolio?

Please add your two cents below.

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