Rebalancing Methods: Percentage vs. Threshold
When it comes to managing your investment portfolio, one of the essential strategies is rebalancing. Rebalancing involves realigning your investments to maintain the desired asset allocation and risk level over time. There are two primary methods for rebalancing: percentage-based and threshold-based. In this article, we will explore both approaches and discuss their pros and cons.
Percentage-Based Rebalancing:
Percentage-based rebalancing involves setting specific target percentages for each asset class in your portfolio. For example, you may decide on a 60% stocks and 40% bonds allocation. Over time, as market fluctuations occur, these percentages can deviate from the initial plan.
To bring the portfolio back in line with your desired allocation, you would sell or buy assets according to the deviation from the target percentages. If stocks outperform bonds and now constitute 65% of your portfolio instead of the desired 60%, you would sell some stocks and buy bonds to restore balance.
The advantage of percentage-based rebalancing is that it ensures disciplined adherence to your long-term investment strategy regardless of market conditions. It forces you to sell high-performing assets (selling high) while buying underperforming ones (buying low), which aligns with Warren Buffet’s famous advice.
However, a potential downside is that frequent trading may result in transaction costs or tax implications if done within taxable accounts. Additionally, too-frequent rebalancing can increase stress levels due to constant monitoring.
Threshold-Based Rebalancing:
Threshold-based rebalancing takes into account deviations beyond a predefined threshold rather than focusing solely on target percentages. With this approach, you set an acceptable range or band around each asset class’s target allocation.
For instance, if your original plan has a stock allocation between 55% – 65%, any deviation outside this range triggers a rebalance action once it exceeds either limit. If stocks drop below 55% or rise above 65%, you would then sell or buy assets to bring them back within the acceptable range.
The advantage of threshold-based rebalancing is that it allows for more flexibility in portfolio management. It takes into account market volatility and avoids unnecessary trading if deviations are minimal, reducing transaction costs and tax implications. Additionally, it reduces the stress associated with constant monitoring.
However, a potential downside is that this approach may result in longer periods between rebalancing events, allowing deviations to accumulate further before taking action. This delay could lead to a portfolio being significantly out of balance during volatile markets and potentially exposing investors to higher risk.
In conclusion, both percentage-based and threshold-based rebalancing methods have their merits. Percentage-based rebalancing ensures adherence to your long-term strategy but may incur higher costs and require more active monitoring. On the other hand, threshold-based rebalancing offers flexibility while minimizing transaction costs but may allow deviations to accumulate before corrective actions are taken. Ultimately, the choice between these methods depends on your investment goals, risk tolerance, time availability for portfolio management, and preference for an active or passive investment approach.