Market Bubbles Are Inevitable; Portfolio Bubbles Are Not - Page 2
“Rules-based” rebalancing offers a more effective approach to managing risk and boosting return.
Here’s how it works.
When the portfolio allocations are initially determined, a "rebalancing threshold" is also established and rebalancing occurs whenever that threshold is hit. You can make it as simple or complicated as you like. The simplest approach is to group similar asset classes together — e.g., U.S. stocks, international stocks, U.S. bonds, international bonds, and specialty assets. In this example, you might have a 30% allocation to U.S. stocks and set your rebalancing thresholds at 27% and 33%. In other words, any time this asset class is over- or under-weighted by 10% or more, you’ll rebalance it back to the target.
A narrower approach would identify targets for each specific asset class (e.g., large-cap U.S. growth stocks, emerging market bonds, real estate, and commodities). Using this approach, an original portfolio allocation of 10% to large-cap U.S. growth stocks might have rebalancing thresholds of 8% and 12%.
The drawback of rules-based rebalancing, outside of a tax-deferred account, is the tax implications of the buy and sell transactions. However, while tax implications must be considered they should never drive your investment decisions. The major benefits of rules-based rebalancing are its systematic approach and its ability to compensate for investors’ emotional tendencies to chase performance and throw in the towel just when the market hits bottom and the rebound begins.
Rules-based rebalancing is not a panacea, but it will prove an effective strategy for most portfolios.