Let’s lay some groundwork before we answer the question. To properly rebalance you must have your portfolio with a firm that can accommodate rebalancing at no cost. You must also have a diversified portfolio as well as a target stock and bond asset allocation that suits your situation. Concentrated, focused or individual stock portfolios are not meant to be rebalanced so don’t try it because it will lead to disaster.

Rebalancing works in three dimensions. The first dimension and by far the most important is the ratio of stocks to bonds. Our research over the last 80 years using daily data shows that almost all the benefits from rebalancing are gained in the first dimension. This means that you should always be aware of the ratio of stocks to bonds in your portfolio. When one gets too far ahead of the other it is time to rebalance. The second dimension is the ratio of stock asset classes to other stock asset classes within the portfolio. The last and third dimension is the ratio of bond asset classes to other bond asset classes in the portfolio.

The rest of this response will focus on how to rebalance in the first dimension or the stock to bond dimension. There are only three ways to rebalance. The first is rebalance based on frequency or time. You rebalance every 2 weeks or every month or every quarter or some other nonsense. Don’t do it. This form of rebalancing does not capture the true benefit from proper rebalancing. It does not maximize the objective of rebalancing which is to reduce risk based on a target allocation. The second is to do it once a year. I actually like this much better for individual investors since it is a once a year thing and dose not require constant supervision. The third and best method is formulaic rebalancing.

Our rule of thumb is to rebalance whenever the ratio of stocks in the portfolio diverges from the target allocation by more than 10%. As an example, for a 50/50 portfolio whenever stocks are either 45% or 55% of the portfolio we rebalance. For a 60/40 portfolio whenever stocks are either 54% or 66% of the portfolio we rebalance. Please note that if you have a 100% stock or bond portfolio you can’t rebalance in the first dimension and you lose the effectiveness of rebalancing. It is an obvious point but important. It is one of the main reasons why you see very few portfolios with allocations in excess of 80% in stocks or with less than 40% in stocks.

If you use our 10% band for rebalancing you will find you get a signal every 8-10 months. Some periods where the markets are volatile will give you frequent signals and others will have you go for long stretches where you do nothing. We prefer this dynamic method for rebalancing because it takes into consideration market volatility.

Mechanically, we don’t reinvest our dividends or interest. This means that when we rebalance and sell an asset class we add this to our money market funds. We include money market funds as part of our bond allocation. This leads to two more questions. If you must rebalance because your first dimension or ratio of stocks to bonds is outside of the target allocation band by 10% which asset classes do you sell and which do you buy.

There are only three logical choices that you can make when selling or buying when you get a rebalancing signal. Number 1—You can sell and buy some of each so that the ratio of the stock and bond asset classes remains the same after rebalancing. Number 2—You can overweight towards the leading or best performing asset class or classes or overweight towards the lagging or worst performing asset class or classes. Number 3—You can rebalance everything back to the original asset allocation. It is important to recognize that at this point you are simply tweaking your portfolio. You are now in the second and third dimension but not the most important one. Rebalancing between stocks and bonds far exceeds the importance of individual stock or bond asset class rebalancing.

For those that are curious—stock asset classes have a persistency effect that means that winners keep winning and losers keep losing. Stock asset classes have a persistency effect. This means that you will make more money if you allocate all of your money to the asset class that is performing the best and raise money from the asset class that is performing the worst. I have not yet released a tale addressing this persistency effect so for now I suggest the reader simply go with alternative Number 3 and rebalance back to the original allocation.

Also, in general what is your opinion about frequency of rebalancing?