The nuances of rebalancing

I recently received a question from a client of mine about an article that referenced rebalancing a portfolio at the same time each year. In theory, an annual rebalance is not a bad way to go. However, there’s quite a bit more to how we manage the rebalancing process than that.

For Merriman clients, we:

• Avoid unnecessary transaction costs by using cash inflows and outflows as a tool to rebalance a portfolio back to its target allocation. Cash inflows are used to buy underweight asset classes and cash outflows are used to sell overweight asset classes.
• Allow assets that are performing well to continue to perform – a documented trend called momentum – by placing tolerance bands around our allocations. This also helps avoid excessive rebalancing transaction costs.
• Favor rebalancing tax-deferred accounts in December to coincide with mutual fund distributions and Required Minimum Distributions (RMDs), again reducing transaction costs.
• Help defer taxes by rebalancing taxable accounts in January, when appropriate.

Market performance can also have an impact on the need for rebalancing. If returns are flat for a few years, there is less need for rebalancing. In volatile times, more.

In addition there will be one-off cases such as:

• Tax loss harvesting. If there is a significant downturn in the markets (think 2008), we can use that as an opportunity to harvest losses to be used against future gains. We did this for our clients in 2008 and it is paying dividends today.
• Introduction or deletion of an asset class can also provide an opportunity to rebalance your portfolio.

Rebalancing your portfolio is an integral step in maintaining a well-balanced portfolio and reducing its risk. But to do it once a year at the same time every year may not be the best solution for you. Depending on your situation, a more customized rebalancing approach may save you significant money in transaction costs and taxes in the long run. As always, check with your advisor to find out what’s right for you.