Rebalancing Strategies: Calendar vs. Threshold Approaches

Diversification is the cornerstone of any profitable long-term investment plan. You create a portfolio with a particular asset mix, like 60% stocks and 40% bonds, that fits your financial objectives and risk tolerance. However, that mix will eventually drift due to the performance of the market. Your portfolio may become 70% stocks and 30% bonds if stocks have a strong year, exposing you to more risk than you had planned.


Rebalancing is necessary in this situation. The methodical process of routinely returning your portfolio to its initial target allocation is known as rebalancing. It's about methodically controlling your risk, not about trying to time the market. Nonetheless, there are two main approaches to rebalancing: the threshold-based approach and the calendar-based approach. The main advantages and disadvantages of these two different approaches will be thoroughly compared in this guide to assist you in selecting the one that best suits your investing style.

Understanding the Rebalancing Imperative 🌍

It's important to comprehend the significance of rebalancing before delving into the two strategies. There are two main risks associated with an unbalanced portfolio:

  1. Increased Risk: Your portfolio may become overly concentrated in stocks if they do well. This puts you at greater risk than you had anticipated. Then, a market decline might cause you to lose far more than you anticipated.

  2. Missed Opportunities: On the other hand, if your bonds do well, you may have too much fixed-income in your portfolio. You might lose out on the stock market's long-term growth potential as a result.

Rebalancing is a traditional "buy low, sell high" strategy that is grounded in discipline rather than emotion. Its objective is to methodically manage these risks by selling assets that have performed well and purchasing assets that have underperformed.

The Calendar-Based Approach: Simplicity and Discipline 📊

The simplest and most popular rebalancing technique is this one. As the name implies, it follows a set timetable, like once every six months, once a year, or once every quarter.

  • How It Works: You mark a date on your calendar, such as the first day of every quarter. Regardless of how much your portfolio has deviated, you bring it back to its target allocation on that day. You sell some of your stocks and purchase more bonds until you reach the target of 60% stocks and 40% bonds in your portfolio.

  • Key Benefits:

    • Simplicity: It is very simple to put into practice. You decide on a date and keep to it. There isn't any guesswork.

    • Discipline: It eliminates all feelings from the process of rebalancing. You are merely adhering to a set of established guidelines; you are not attempting to time the market. A calendar-based approach offers a disciplined framework that helps to mitigate the behavioral biases that frequently result in bad investment decisions, according to a 2024 Vanguard study on rebalancing.

  • Drawbacks: A calendar-based approach's primary disadvantage is its lack of flexibility. At the bottom of a market decline, for instance, you might rebalance at a bad moment. Additionally, it may result in more frequent purchases and sales, raising transaction costs and possibly raising capital gains taxes.

The Threshold-Based Approach: Flexibility and Efficiency 🧭

This rebalancing approach is more adaptable and, for some, more effective. It is based on a threshold rather than a calendar. Only when the allocation of your portfolio has deviated by a specific amount do you rebalance.

  • How It Works: You establish a cutoff point for your portfolio, such as 5% of your intended allocation. Only when your stocks have increased to 65% or decreased to 55% would you rebalance your portfolio if your goal is 60% stocks and 40% bonds. By doing this, you can be sure that you are only rebalancing when absolutely required.

  • Key Benefits:

    • Flexibility: Compared to a calendar-based method, it offers greater flexibility. Rebalancing at an unfavorable moment is not required of you.

    • Cost-Efficiency: Since you are only rebalancing after the market has moved significantly, it may lead to fewer trades and lower transaction costs. Additionally, this can lessen the effect of capital gains taxes. According to a 2023 Charles Schwab report on rebalancing, managing a portfolio using a threshold-based strategy may be more tax-efficient.

  • Drawbacks: The primary disadvantage of a threshold-based strategy is that it necessitates more frequent monitoring. You must continuously monitor the allocation of your portfolio. Because your portfolio is permitted to deviate further from its target allocation before a rebalance is initiated, it may also result in an increased degree of risk.

Which Approach Is Right for You? A Strategic Decision 📊

Neither strategy is a universally applicable solution. Your individual investing style, risk tolerance, and willingness to keep a close eye on your portfolio will all influence the best course of action for you.

  • For the Hands-Off Investor: A calendar-based approach is the obvious choice if you're a hands-off investor seeking a straightforward, methodical, set-it-and-forget-it strategy. You can make the change, put a reminder on your calendar, and then resume your normal activities.

  • For the Active Investor: A threshold-based strategy might be a better choice if you are an investor who is prepared to keep a close eye on your portfolio and is worried about transaction fees and taxes.

  • The Blended Approach: The two approaches can also be combined. For instance, you could use a threshold overlay in conjunction with a calendar-based strategy. In addition to rebalancing once a year, you also do so if the allocation of your portfolio deviates by more than 10%. This offers a good mix of flexibility and discipline.

The fact that you have a strategy at all is more important for rebalancing than the particular approach you take. One of the most effective strategies for controlling risk and making sure your portfolio stays in line with your long-term financial objectives is a methodical, disciplined approach to rebalancing.

FAQ

Q: Is rebalancing a guarantee of higher returns? A: Not at all. Higher returns are not assured by rebalancing. A portfolio that is not rebalanced may perform better than one that is during a robust, long-term bull market. Rebalancing is done to control risk, not to increase profits.

Q: How often should I rebalance? A: Rebalancing once a year is a typical strategy. Transaction costs may increase with a more frequent rebalance (quarterly, for example). The volatility of your portfolio and your own investing style will determine the ideal frequency.

Q: Does rebalancing trigger a taxable event? A: In agreement. Any profit you make when you sell an asset to rebalance your portfolio will be liable to capital gains tax. A threshold-based strategy can lessen this major rebalancing disadvantage by reducing the number of trades.

Q: Can I rebalance with new money? A: In agreement. By allocating your new investments to the asset classes that have underperformed, you can rebalance your portfolio. Rebalancing your portfolio in this way is a great way to avoid a taxable event.

Disclaimer

This article is not intended to be financial or investment advice; rather, it is merely informational. Investment value is subject to change, and returns are not guaranteed. Before making any investment decisions, readers should perform their own extensive due diligence and speak with a qualified financial advisor because rebalancing is a risky strategic tool.

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