Two good ways, and one really bad way to rebalance your portfolio

I recently posted a top 100 list of ETFs by expense ratio.  We must remember that these ETFs are the tools that we plug into an investment strategy to implement it, rather than the end goal themselves.  There are a plethora of strategies out there, they are based around the concept of the efficient frontier, first proposed in this paper by Markowitz (1952). The notion of the efficient frontier is that you can find a theoretical point of efficiency between risk and reward by striking the right balance between several asset classes.  Simply put, having a mix of stocks and bonds in the right balance will return more profit, for less risk, than being wholly in one class or the other.

If you did not use a variation of the efficient frontier concept, and instead invested solely in a single asset, ETF fees are fairly simple to understand.  There is a Net Expense ratio, a Capital Gains tax (fee) and possibly transaction fees.  In this case you simply buy X number of an ETF like VTI, and when you have more cash later on, buy more of the same. However, once you have a strategy that has ratios of different asset classes, you must consider rebalancing in order to maintain the ratios.

Rebalancing a portfolio is necessary when it drifts away from your target allocations.  In a Basic Two portfolio, you might have two assets, one that represents total stock market, and one that represent total bond market.  This could be implemented using two ETFs  (VT, BND) if your initial investment was $10,000 and you have an 80/20 split you would start out with $8000 in VT, $2000 in BND.  If the stock market fund VT increases by 20% and the BND by 5% you have drifted away from your investment strategy.

Three ways to rebalance

Buy and Sell Rebalance (doing it wrong)

Per the example above $10K has grown to $11.7K or a 17% increase.  Your current asset allocations have become 82/18.  If you just liquidated everything, and purchased again at 80/20 the following would occur:

• Sell VT/BND
• New VT/BND position 0/0
• New Cash position 100% ( $11.7K)
• Transaction Fees (if applicable) = 4 events (sell VT, Sell BND, Buy VT, Buy BND)
• Tax Event on $1,700 of capital gain (within taxable account)
• Buy VT/BND position 80/20 ($9,360, $2,340)

Buy and Sell Rebalance (done right)

As you can see from the above, you don’t need to sell everything in order to rebalance, you just need to make the VT amount into $9,360, and the BND amount into $2,340.  Your starting amounts in the 82/18 level are $9600 and $2,100.  Rebalancing ‘smartly’ would entail:

• Sell $240 of VT, Buy $240 BND
• New position 80/20 ($9,360, $2,340)
• Transaction fees if applicable reduce from 4 events to two events
• Tax Event is capital gain on $240 rather than $1700

As you can see from the above the ‘right way’ makes a lot of sense, and there is no circumstance where the wrong way should be used, though it is a an easy way to run the math on your target rebalance amounts.

Buy Only Rebalance

Buy only is done by injecting more money into the system, using the same example:

• Buy $300 BND
• New position 80/20 ($9,600, $2,400)
• Transaction fees reduce to one event
• No tax event

Asset location matters

As you can see from the above there are two practical ways to rebalance- buy and sell or buy only.  However, it is often the location of your assets that can determine which can be implemented.  For example, if you are trading within a tax advantaged account, such as an IRA or 401(k) then you might not be able to use a Buy Only strategy, as that requires adding new money to the account.  The annual limits may restrict that option.  Luckily, you don’t realize capital gains in such accounts, so the Buy and Sell rebalance works perfectly here.

However, in a taxable account, you can always add more money, providing you can afford it, so you can perform a Buy Only strategy here, providing you have the financial means.  Taxable accounts should avoid the buy and sell strategy if possible, as we want to control capital gains taxes.

Don’t forget the big picture

It is important to think holistically about your assets, rather than by Asset Location alone. For example, if you cannot use a buy only strategy to rebalance your 401(k) there is nothing stopping you loading the relevant amounts to create the rebalance in a taxable account.  This creates interesting opportunities for Tax Loss Harvesting also.  Additionally,you should decide if spousal assets should be factored into an overall allocation plan, or if you want to take a cellular approach.

Conclusion

Think about Buy and Sell vs Buy Only, and be aware of what the impact of each is.  For transactions that are shielded from taxes, it matters less if you lock in gains. For accounts that have annual tax liabilities, be careful not to lock in capital gains taxes, especially short term ones, as the costs of doing so can negate the value of rebalancing.