Oblivious Investor

A reader writes in, asking:

“We are getting closer to retirement and beginning to adjust our asset allocation. Recently we rebalanced our asset allocation from 90/10 stocks/bonds to 70/30. It was the first time we rebalanced in about 7 years. We think given our time horizon we should consider 50/50 or even 40/60. It’s a very difficult decision.

In addition, we’re trying to figure out how often we should be rebalancing going forward as we move into retirement.

How do we figure out what is the best rebalancing frequency for our funds held at Vanguard: Total Stock Market Index Fund, Total Bond Market Index Fund and Intermediate Term Bond Index Fund? Those funds are our complete retirement portfolio…trying to make you proud…KISS. You helped us so much in the 10+ years that we have been following you.”

First a note on terminology, because it may cause some misunderstandings when reading the links I’m about to provide: the change that you describe having recently made is not rebalancing. Rebalancing is when you bring your allocation back to the intended (target) allocation. For example, if the target is a static 60/40 allocation and every quarter you make adjustments to bring the portfolio back to the 60/40 allocation, that’s rebalancing. If you change the target (e.g., deciding instead that a 40/60 allocation is the new target), that’s not rebalancing.

This is not to say that changing the target is a bad idea. Sometimes it’s a good idea — especially as your life circumstances change. I’m just belaboring this terminology point, because when reading about rebalancing in more technical writing, it’s important to know very specifically what is being discussed. (This is a common terminology mix-up, by the way. People get it wrong constantly on the Bogleheads forum for instance.)

And with that out of the way, the following are a few things you may want to read.

• Momentum (classic 1999 article from Bill Bernstein)
• An In-Depth Look at Portfolio Rebalancing Strategies (2015 research paper from Michael Kitces)
• Finding The Optimal Rebalancing Frequency – Time Horizons vs Tolerance Bands from Michael Kitces

A takeaway from reading the three articles above is that rebalancing more often than annually is likely not a great idea. In very brief, the reason is that the stock market has historically exhibited a slight degree of momentum over periods shorter than a year. That is, if yesterday was a good day, today is more likely than usual to be a good day. And if yesterday was a bad day, today is more likely than usual to be a bad day. And the same goes for monthly periods.

And the result is that rebalancing daily or monthly would mean that, in a market downturn, you’re constantly buying more stocks as they keep falling, resulting in an overall loss that’s worse than if you hadn’t been rebalancing. And during upward markets, you’re constantly selling stocks, resulting in less of a gain than if you hadn’t been rebalancing.

The following two links are runs from PortfolioVisualizer, comparing monthly vs annual rebalancing, for a basic 3-fund portfolio using a “4% rule” spending strategy. Rebalancing annually worked out slightly better in terms of return, maximum drawdown, and standard deviation. (Note that I’m simply using the earliest start date available here, and letting it ride until today. If interested, you could instead test with rolling 30-year periods, for instance, to see how reliable this outcome is. You could also test with different target allocations or with different spending strategies.)

• Rebalancing annually
• Rebalancing monthly

Plot Twist: Contrary Evidence

There’s also, however, a 2010 paper from Vanguard (no longer on their website, but here’s a Web Archive link), which found essentially no difference between rebalancing monthly, quarterly, or annually — other than the time (and potentially transaction costs) involved in doing so.

Also, as always, anything based on historical data — as all of the above is — should be treated with a healthy degree of skepticism. Sometimes, trends that persisted for a very long period, even many decades, eventually disappear, as the markets themselves change (e.g., as the participants in the market shift, as products available change, as laws/regulations change, etc.)

And indeed, per a 2022 paper, it appears that that’s exactly what has happened:

• Autocorrelation of stock and bond returns, 1960–2019 from Jonathan Lewellen of Dartmouth College

In this paper, the author found that the autocorrelation of stock returns (i.e., the correlation from yesterday’s returns to today’s returns) declined over the period 1960-2019 and actually became significantly negative in the second half of the sample. That is, yesterday being a good day would mean today is more likely than usual to be a bad day, and vice versa. And that would mean that rebalancing everyday (as you would see in a target-date or LifeStrategy fund) would actually be helpful.

So, where does all of this leave us?

Frankly, I really don’t know, other than to say that there’s some good evidence in favor of just about any option. My personal thinking at this point can be summarized as follows:

• If you have a target-date fund, LifeStrategy fund, or anything similar which is rebalancing for you daily, that’s probably fine. (Though it can create tax costs in a taxable account.)
• If you’re using a DIY allocation, and you want to rebalance quarterly, annually, or every two years (or “annually but only if the allocation is off-target by at least x%”), that’s probably fine too.
• More frequent rebalancing means more work, if you’re doing the rebalancing yourself.
• I wouldn’t worry too much about this topic overall. Nor would I put too much faith in Strategy A instead of Strategy B. It’s more along the lines of “pick one approach that seems reasonable, and stick with it.”