Each of our clients has a specific allocation target for every asset class and category in which we invest.  An example might be the following[1]:

Because market movement causes a portfolio’s allocation to continuously drift from its intended targets, every good investment plan requires rules for how and when the investor will “rebalance” (i.e., reallocate the portfolio back towards its targets).

Individual investors – assuming they rebalance at all (which of course assumes they have defined asset class targets to begin with!) – typically rebalance based on calendar intervals.  Once per quarter or year, they will make the necessary trades to get all asset classes back to target.  While this method is better than nothing, it inevitably results in rebalancing either too infrequently (during volatile periods, when a portfolio can quickly become improperly allocated) or too frequently (during calm periods, when trading simply because the calendar says so can create unnecessary transaction costs and tax liabilities).

Evidence has shown that a better method is “opportunistic rebalancing,” which uses rules based on deviation from target instead of the calendar.  This requires the investor to define minimum and maximum acceptable allocations for every asset class and category.  An example for our clients might be the following[2]:

By defining minimum and maximum acceptable allocations, we create a “tolerance band,” or the range of allocations within which a given class or category can acceptably float before rebalancing becomes necessary.  We periodically monitor every client’s portfolio to ensure that no asset class or category has drifted outside of its acceptable range.  If any have, we take action, making the necessary trade(s) to rebalance the out-of-tolerance class or category back to its target.[3]

We apply two additional filters before making any rebalancing trade:

First, for every trade we make in a client’s portfolio (rebalancing or otherwise), we perform a cost-benefit analysis to ensure that the expected benefit outweighs the cost, namely any transaction costs and/or taxes that the trade would produce.  Ideally, rebalancing trades can be made in a client’s 401(k) or other tax-advantaged account, where realizing taxable gains is not a concern, but that is not always an option.  In certain situations, if we determine that the cost outweighs the benefit, one or more asset classes may be temporarily allowed to drift outside of their normally acceptable ranges.

Second, we apply a client-specific lens.  If, for example, we know that the client will soon receive a bonus that will result in an influx of cash that could be used to rebalance the portfolio back to target, using the new cash to rebalance is almost always preferable to trading existing positions.  Because of this and similar client-specific situations, every trade must first be approved by the client’s Wealth Advisor.

Lastly, it’s worth mentioning why we rebalance portfolios.  While it’s true that the process likely generates a “rebalancing bonus” (i.e., any process that systematically sells positions that have gone up and buys positions that have gone down should benefit from mean reversion in the long-term), that’s not our primary motivation for rebalancing.  Instead, we rebalance because the intended targets are what we believe most appropriately match the client’s goals and risk tolerance.  An investor’s goals – and not the ebbs and flows of global markets – should determine their portfolio allocations.

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[1] While the allocations shown here are hypothetical (each of our clients has allocation targets specific to their unique goals and risk tolerance), this example is reasonably representative of the typical Geometric client’s portfolio.  If you’re curious about how we arrived at this portfolio mix, feel free to contact us.

[2] We use the “5/25 rule,” popularized by Larry Swedroe, to define our minimum and maximum acceptable allocation levels.  This rule states that rebalancing should occur only if an asset class or category has drifted from its original target either by an absolute 5 percent or by 25 percent of the original target, whichever is less.

[3] By definition, if one asset class or category is above or below its target, one or more other class or category is off in the opposite direction, though not always by so much that it has drifted outside of its acceptable range.