You will be able to compare the two main rebalancing rules and choose one for your portfolio.
Grace asks three friends how often they rebalance. One says every January, without fail. One says whenever anything is more than five points off target. The third says she rebalances "when it feels right", which turns out to mean never. Grace realises the first two have something the third does not: a rule she could write on a card.
Lesson 6.1, Why your allocation drifts, showed what happens without a rule. This lesson compares the two main kinds of rule and the hybrid many people end up using, so you can pick one.
Calendar rebalancing resets your portfolio to its target on fixed dates, whatever has happened in between. Once a year is the most common choice. Some people do it every six months or every quarter.
On the date, you add up your holdings, compare each percentage with your target and trade back to the target. If shares are at 68% and your target is 65%, you move three points from shares to bonds. If they are at 65.4%, you move 0.4 points.
The strength of a calendar rule is that it is simple. You can put the date in your calendar today and never think about rebalancing in between. It is also easy to follow when markets are calm, because there is no decision to make, only a task.
Its weakness is that it ignores what happens between dates. If shares fall 35% in March and your date is in January, your portfolio runs far below its share target for most of a year before the rule notices. And a calendar rule can make you trade when the drift is tiny, paying commission and spread for very little benefit.
Threshold rebalancing acts only when an asset drifts outside a band around its target. A common band is five percentage points either side. With a 65% share target, you would rebalance if shares rose above 70% or fell below 60%, and leave everything alone in between.
Its strength is that it responds to big moves when they happen. After a sharp fall, shares may cross the lower edge of the band within weeks, and the rule tells you to buy while prices are down. Small drifts never trigger a trade, so you pay trading costs only when the drift is worth correcting.
Its weakness is that you have to check. A threshold rule only works if someone looks at the numbers often enough to notice when a band is crossed, which means at least monthly, and more often when markets are moving fast. That is easy to plan and hard to keep doing for years. It also tends to fire at the most uncomfortable moments, after a big rise or a big fall, which is exactly when you are least inclined to follow it.
The width of the band is a judgement. Narrow bands, such as two points, trigger frequently and cost more in trading. Wide bands, such as ten points, let your risk drift a long way. Five points is a common middle ground, not a magic number, so pick a width you can defend.
A common hybrid combines the two. You check on a fixed date, say once a year or every six months, and you rebalance only if a band has been crossed. If it has not, you do nothing until the next date.
Farhan chooses this. His rule reads: "On the first Saturday of January and July, I add up my holdings. If shares are above 70% or below 60%, I rebalance back to 65/35. Otherwise I do nothing."
The hybrid keeps the simplicity of a date, so he knows when to look. It keeps the restraint of a band, so he does not trade over trivial drifts. What it gives up is the instant response of a pure threshold rule: a crash in February might not be acted on until July. Many investors accept that, because a rule checked twice a year will actually be followed, while a rule that needs weekly checking often gets abandoned.
Some investors add one exception: after a very large market move, say shares falling by a third, they check outside the calendar. If you add an exception like that, write the trigger in advance, so it does not become a reason to check every day.
The best rule is the one you will follow in a crash and in a boom. If you are someone who checks the app daily anyway, a threshold rule uses that habit well. If you would rather look twice a year and forget the rest, choose a calendar or the hybrid. If you invest every month, keep in mind that new money can do much of the rebalancing for you, as lesson 6.3 shows, which makes the rule's dates matter a little less.
Grace chooses a pure calendar rule, once a year in her birthday month, because she knows she will not check monthly. When you write yours, include the dates or the bands, and one honest sentence on why it fits how you actually behave.
Choose a calendar, threshold or hybrid rule, write the dates or bands, and explain the choice in two sentences.
Junxiong-WFG Organisation is an authorised representative of AIA Financial Advisers Private Limited (Reg. No. 201715016G).