T. Rowe Price Personal Investor - What’s The Best Approach for Portfolio Rebalancing? (2024)

Having an asset allocation that is appropriate for an investor’s goals is important, and periodic rebalancing helps keep a portfolio in line with its allocation target. However, one of the challenges of effective rebalancing lies in how one defines “periodic.” Rebalance too often and investors may miss out on some positive momentum in their stock investments, as well as potentially incur unnecessary taxes in a taxable account. But go too long without rebalancing and a portfolio’s allocation may shift enough that it no longer meets an investor’s objectives. It could carry more risk than is appropriate for an investor’s risk tolerance or have less growth potential than what’s needed to achieve investment goals.

Research suggests investors can benefit from monitoring allocations frequently but only rebalancing if the portfolio drifts away from the target allocation by a meaningful amount. Two key questions are: How much drift should be allowed before investors rebalance, and how can they implement this strategy? To help answer the first question, T.RowePrice conducted research using rolling 10-year periods from historical market data dating back 25 years. The analysis compared various rebalancing methodologies against three hypothetical model portfolios, evaluating which methodology provided the best return. (For detailed information, see More Details on the Study Methodology.)

The foundation of most investment plans is a target allocation that balances risk with the need to generate enough growth to meet the investor’s financial goals. This target allocation could change over time as an investor’s time horizon or goals change. A portfolio may need to be brought back into alignment with its target allocation due to market performance: Certain assets in the portfolio may outperform others, thus causing the allocation to shift. That misalignment could affect either the overall mix or the individual securities.

Rebalancing is typically accomplished by selling outperforming assets and using the proceeds to invest in opportunities in another asset class. To avoid emotional decisions about when to buy and sell, investors can rely on a system of rules to determine when to rebalance. Those rules typically involve setting an allocation threshold, such as a percentage, that triggers rebalancing. Some common approaches for these tolerance bands involve using percentages based on a fixed band or a relative band. While there are other options, fixed and relative bands have garnered attention from researchers, as they are relatively easy for people to understand and for software systems to implement.

The fixed band approach sets a fixed threshold, say two percentage points, both above and below the target allocation. If a holding strays beyond that band, it’s time to rebalance. For example, a portfolio with 20% of its total assets invested in a domestic bond fund should rebalance if rising bond prices (or falling prices in other investments) drive the bond allocation above 22% of the portfolio (or if market activity pushes the bond allocation below 18%).

By comparison, a relative band sets the trigger as a percentage of the actual allocation target. For example, a 20% relative band on the same domestic bond allocation target would mean a rebalancing trigger of four percentage points above or below the target allocation (that is, 20% of the 20% bond allocation). Therefore, the portfolio would be rebalanced if that fund’s allocation goes above 24% or below 16%.

Note that with a relative band, investments with small or large allocations should be similarly likely to trigger rebalances. With fixed bands, rebalances tend to be driven by investments with large allocations that drift outside their bands. For example, it takes much less market volatility to move an investment from a 36% allocation to 39% than from 4% to 7%. There is something intuitively appealing to relative bands. However, we did not want to assume that any approach would be best in the real world before analyzing the data.

The T.RowePrice analysis demonstrated that, in general, rebalancing is a valuable strategy for investors to use in managing their portfolios. Rebalancing strategies only underperformed the non-rebalanced control portfolio during time periods driven by long bull markets. This finding is to be expected: In the absence of a bear market, a higher allocation to equity has historically yielded better returns, even when that allocation is not in line with an investor’s risk tolerance. However, developing an investment strategy based on bull markets alone is very risky and not recommended. Choosing not to rebalance could easily lead to underperformance in an eventual bear market.

So, if rebalancing helps, what specific strategy helps the most? In the T.RowePrice study, the wider tolerance bands generally outperformed the narrower bands. Depending on the model, either the 3% fixed band or 25% relative band was the best-performing method based on return. (See "Rebalancing with Different Strategies.")

In addition to performing well on average, the wider bands were most often the best across the full range of portfolios and scenarios. They performed particularly well in periods with bear markets.

The analysis also found that the level of equities in the portfolio was a factor in determining the performance spread between rebalancing and not rebalancing. The most pronounced difference in median returns occurred for the 60% equity portfolio, followed by the 90% portfolio. These findings are in line with other industry analyses.

This analysis helps answer the first question of how much portfolio drift to allow before it makes sense to rebalance. It also underscores the value of rebalancing. The graph, "How Rebalancing Can Affect Overall Portfolio Return," illustrates one hypothetical example of how rebalancing events might have occurred over a specific 10-year period, and how that could have changed the portfolio value.

The second question may be harder: How can an individual implement a systematic, tolerance-based approach?

If an investor is managing their own portfolio, they may be rebalancing periodically (perhaps on an annual basis) or using their own judgment as to when they think the markets have gotten carried away. Those methods can succeed in getting an investor’s allocation and risk level back to where they want them. However, the performance of a calendar-based approach can depend heavily on whether their decision to rebalance happened at a favorable time or not. The judgment-based approach is a lot like market timing, which is notoriously difficult to implement successfully and prone to behavioral biases.

Can an individual shift from one of those methods to a systematic approach? Monitoring a portfolio’s overall allocation on a monthly basis is possible, but very challenging for a typical investor. Checking allocations daily at the individual security level against a threshold is virtually impossible without a lot of help from technology.

Fortunately, some investment services rebalance portfolios automatically using this type of threshold parameter, setting both the percentage threshold and whether it is a fixed or relative band. For instance, T.RowePrice’s Retirement Advisory Service uses frequent evaluation of drift in its portfolio management system.

Investors should talk to a financial professional about what method they could use to rebalance their portfolio. When using a service with a systematic approach, learning how these thresholds work can help an investor understand why their portfolio has been rebalanced (or perhaps why it hasn’t been rebalanced) as market conditions develop. Our Retirement Advisory Service uses wide tolerance bands, which delivered strong outcomes in our analysis. Even though it doesn’t trigger rebalancing as often as other methods, we believe this approach offers our clients a good combination of risk management and potential performance.

Important Information

All investments are subject to market risk, including the possible loss of principal. This material has been prepared for general and educational purposes only.

This material does not provide recommendations concerning investments, investment strategies, or account types. It is not individualized to the needs of any specific investor and is not intended to suggest that any particular investment action is appropriate for you, nor is it intended to serve as the primary basis for investment decision-making. Any tax-related discussion contained in this material, including any attachments/links, is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding any tax penalties or (ii) promoting, marketing, or recommending to any other party any transaction or matter addressed herein. Please consult your independent legal counsel and/or tax professional regarding any legal or tax issues raised in this material.

The T.RowePrice Retirement Advisory Service^™ is a nondiscretionary financial planning service and a discretionary managed account program provided by T.RowePrice Advisory Services, Inc., a registered investment adviser, under the Investment Advisers Act of 1940. Brokerage accounts for the Retirement Advisory Service are provided by T.RowePrice Investment Services, Inc., member FINRA/SIPC, and are carried by Pershing LLC, a BNY Mellon company, member NYSE/FINRA/SIPC, which acts as a clearing broker for T.RowePrice Investment Services, Inc., T. Rowe Price Advisory Services, Inc. and T.RowePrice Investment Services, Inc. are affiliated companies.

Rebalancing cannot assure a profit or protect against loss in a declining market. Past performance cannot guarantee future results.

The views contained herein are those of the authors as of February 2024 and are subject to change without notice; these views may differ from those of other T.RowePrice associates. All charts and tables are shown for illustrative purposes only.

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