800px-Model_Balancing

Rebalancing your portfolio is a time honored tradition, that seems to happen at the beginning of the year.  Often you’ve assigned that maybe 20% of your portfolio will be in bonds, 60% in United States stocks and 20% in foreign stock markets.  The percentages aren’t really the point here, but let’s just suppose that, for your portfolio, those were the weights you chose.  Over the course of the year some parts of your portfolio go up, and some parts of your portfolio go down.  This leaves you with a weighting that you may not have originally intended.  For example, if the US stock market crashed but foreign markets did well you might end the year with a weighting that looks more like 25% in bonds, 40% in US stocks and 35% in foreign stocks.  The standard prescription for this situation is to sell a bit of your bonds, and a bunch of your foreign stocks in order to buy more US stocks, so that you return to your original portfolio weighting.

The Benefit

Clearly the goal here is both to return yourself to a weighting you originally thought was wise, (this should dovetail with your investment policy statement) and to force yourself to sell high (the foreign stocks in our previous example) and buy low (the US stocks).  The idea is that, over time, you’ll do better in the market as a whole because you were able to take advantage of times when the various markets were relatively cheap, and were able to maintain some gains in markets that had run up over the last year.  This additionally keeps you from taking more risk than you’d intended.  For example, if you were near retirement and the year was 1997.  In that year the S&P 500 went up 33%!  That could mean that your portfolio was suddenly more like 35% bonds and 65% stocks.  This would mean that, going into your retirement, you have a much riskier portfolio than you had intended.  You solve this by simply selling your excess stocks, and buying bonds.  Suddenly your expected risk is back roughly where you left it.

The Problem

As you might be aware by this point, in my ideal portfolio you never do anything except buy more assets.  Whenever you sell an asset, even an index fund, you trigger capital gains taxes.  Triggering capital gains taxes will create a drag on your returns.  A good example comes from Charlie Munger from the Berkshire Hathaway Annual Meeting 2008:

Another very simple effect I seldom see discussed by either investment managers or anybody else is the effect of taxes.  If you’re going to buy something which compounds for 30 years at 15 percent per annum and you pay one 35 percent tax at the very end, the way that works out is that after taxes, you keep 13.3 percent per annum.  In contrast, if you bought the same investment but had to pay taxes every year of 35 percent out of the 15 percent that you earned then your return would be 15 percent minus 35 percent of 15 percent or only 9.75 percent per year compounded.  So the difference there is over 3.5 percent. And what 3.5 percent does to the numbers over long holding periods like 30 years is truly eye-opening.  If you sit back for long, long stretches in great companies, you can get a huge edge from nothing but the way that income taxes work.

For reference 3.5% is roughly a doubling every 20 years.  So if we never want to sell because we’ll lose out on a few percent, how can we keep our portfolio balanced?

The Solution

Fortunately, as long as we’re young and have a relatively low net worth.  As long as your income is larger than your portfolio you can pretty well rebalance without selling.  If your portfolio is out of your desired balance you can simply tilt your new contributions to try to catch the balance up to what you originally intended.  For example, if after the pullback in the market we’ve had, you’ve found that the percentage of your portfolio invested in stocks has fallen maybe 10% lower than your target.  To make up for this you could simply throw your entire contribution at stocks until the gap was righted, or even better you could continue making your regular contribution and split it up as usual, but also make extra contributions to catch your stocks back up to where they ought to be.  These plans are feasible if you’ve got a $60,000 portfolio, and now your target is off by $6,000.  If you have a $600,000 portfolio this all requires some more thought.  You’ll have to try to determine if losing out on some of your return over the long haul is worth reducing your risk by keeping your portfolio on target.  My suspicion is that you’ll find it worthwhile.