Research summary

Tuning in to the right frequency for rebalancing

November 01, 2022

There are risks in letting your asset allocation drift too far from your target—including ending up with more risk in your portfolio than you signed up for. At the same time, there are taxes and trading costs associated with rebalancing. In a recent paper, Vanguard investment strategists analyzed approaches to portfolio rebalancing and how it can be optimized.

Three ways most investors rebalance

The Vanguard team examined three methods often employed by investors, advisors, and asset managers for rebalancing portfolios:

  • Calendar-based rebalancing designates a frequency for resetting the portfolio back to the target asset allocation. More frequent rebalancing results in lower tracking error and higher transaction costs, absent cash flows to aid in rebalancing.
  • Threshold-based rebalancing is triggered when the portfolio breaches a specific percentage of deviation from the target allocation. One major drawback of threshold-based rebalancing: It requires that the portfolio be monitored daily and is thus not practical for investors who manage their own portfolios. The smaller the threshold, the lower the tracking error and the higher the transaction cost.
  • Calendar- and threshold-based rebalancing combines both rebalancing approaches. Based on a calendar frequency, the portfolio is rebalanced if it has strayed by more than a specific percentage from the target allocation.
A comparison of common rebalancing methods
The frequency component, threshold component, and destination component are displayed for each of the three categories of rebalancing methods: calendar-based, threshold-based, and the combination rule (or calendar- and threshold-based). The strategies tested in the category of the calendar-based method are daily, weekly, biweekly, monthly, quarterly, semiannual, annual, biennial, and no rebalancing. The strategies tested in the category of the threshold-based method are 1% to 15%. The strategies tested in the category of the calendar- and threshold-based method are monthly and 1% to monthly and 15%, quarterly and 1% to quarterly and 15%, semiannual and 1% to semiannual and 15%, and annual and 1% to annual and 15%.

Source: Vanguard.

Which method is optimal?

Our strategists employed a framework for determining an ideal risk-return and cost-efficient rebalancing strategy. You can learn more about the methodology in the research paper. It requires forecasting a distribution of asset returns (an entire range of returns rather than a single-point forecast) and transaction costs, which are critical in assessing the impact of rebalancing on portfolio wealth after transaction costs are taken into account.

For investors who don’t participate in tax-loss harvesting or who are not concerned with maintaining tight tracking to a multiasset benchmark portfolio, rebalancing a portfolio on an annual basis was the best method in terms of the risk-return trade-offs. It is optimal largely because it allows investors to harvest the equity risk premium while also generating lower transaction costs than more frequent rebalancing.

Rebalancing methods and their projected impact on post-transaction-cost wealth
The optimal rebalancing methods are listed for different equity allocations. The first column is the equity allocation, ranging from 35% to 90%. The second column contains the optimal rebalance method and those that are not materially different from the optimal. Annual is included for all equity allocations. The third column is the certainty fee equivalent, or CFE, for annual relative to quarterly and 5% rebalance, ranging from 6 to 14 basis points. The fourth column is the CFE for annual relative to quarterly rebalance, ranging from 10 to 16 basis points. The last column is the CFE for annual relative to monthly rebalance, ranging from 21 to 28 basis points.

Notes: Results are based on simulations from the forecasting framework and maximization of post-transaction-cost wealth for various portfolios and rebalancing strategies shown above. The CFE (certainty fee equivalent) is the benefit of selecting the optimal rebalancing strategy relative to another rebalancing method or, conversely, the fee an investor would be willing to pay relative to another rebalancing method. “Bps” equals basis points; a basis point is one-hundredth of a percentage point. U.S. bonds are represented by the Bloomberg U.S. Aggregate Bond Index, non-U.S. bonds by the Bloomberg Global Aggregate ex-U.S. Index, U.S. equities by the MSCI US Broad Market Index, and non-U.S. equities by the MSCI All Country World Index ex USA. Data are as of June 2022.

Source: Vanguard.

Do exceptional markets merit exceptional rebalancing?

While stock market declines like the one we’ve experienced this year may tempt investors to rebalance more frequently, our research indicates that less-frequent rebalancing is efficient even during periods of market turmoil. Transaction costs tend to rise during volatile environments, which makes rebalancing expensive. Moreover, an investor may rebalance in one direction and then have to reverse the transaction because the market whipsawed the opposite way, which can happen during periods of turmoil.

The bottom line

Our research shows that optimal rebalancing methods are neither too frequent, such as monthly or quarterly calendar-based methods, nor too infrequent, such as rebalancing only every two years. For many investors, implementing an annual rebalancing is optimal.

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Notes:

All investing is subject to risk, including the possible loss of the money you invest. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.

Investments in bonds are subject to interest rate, credit, and inflation risk.

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