Time based rebalancing

What Is Time-Based Rebalancing?

Time-based rebalancing is a portfolio management strategy where an investor restores their portfolio's asset allocation to its original, desired proportions at predetermined, regular intervals, regardless of market movements. This approach systematically brings the portfolio back in line with the investor's risk tolerance and investment objectives by adjusting the weights of various assets. For example, an investor might choose to perform time-based rebalancing quarterly, semi-annually, or annually. The core idea is to counteract portfolio drift, which occurs as different asset classes perform unevenly, causing their percentages within the portfolio to deviate from the target allocation.

History and Origin

The concept of rebalancing portfolios is a natural extension of modern investment principles, particularly those stemming from Modern Portfolio Theory (MPT), pioneered by Harry Markowitz in the 1950s. MPT emphasizes the importance of diversification and selecting an optimal mix of assets to maximize expected return for a given level of risk.²³, While a specific "invention date" for time-based rebalancing is not cited, the practice of periodically adjusting a portfolio to maintain its intended risk profile became a common discipline for investors and financial professionals alike as the principles of asset allocation gained widespread adoption. Early studies, such as those by Arnott and Lovell in the late 1980s and early 1990s, explored the benefits of disciplined portfolio rebalancing, often comparing different frequencies.²²

Key Takeaways

• Time-based rebalancing involves adjusting a portfolio's asset weights back to target levels at fixed intervals (e.g., annually, quarterly).
• Its primary goal is to maintain the portfolio's intended risk tolerance and asset allocation, rather than to maximize returns.
• The strategy provides a disciplined, systematic approach to portfolio maintenance, reducing the influence of emotional decision-making.
• It inherently involves selling assets that have performed well (selling high) and buying those that have underperformed (buying low) to restore balance.
• Potential drawbacks include incurring transaction costs and generating tax implications in taxable accounts.

Interpreting Time-Based Rebalancing

Time-based rebalancing is interpreted as a commitment to a predefined asset allocation strategy. By setting a fixed schedule, investors aim to neutralize the impact of market volatility on their long-term financial plans. If a portfolio component, such as equity, experiences significant capital appreciation, its weight in the portfolio will increase. Conversely, if fixed income assets decline or grow slower, their weight will shrink. Time-based rebalancing ensures that these deviations are corrected at regular intervals, preventing the portfolio from becoming excessively risky or too conservative relative to the investor's initial plan. This disciplined approach aims to keep the portfolio aligned with the investor's comfort level for risk throughout their investment horizon.

Hypothetical Example

Consider an investor, Sarah, who begins with a target allocation of 60% stocks and 40% bonds. She decides to perform time-based rebalancing annually, every December 31st.

Initial Portfolio (January 1, Year 1):

• Stocks: $60,000
• Bonds: $40,000
• Total Portfolio: $100,000

After One Year (December 31, Year 1):
Due to strong market performance, Sarah's stocks appreciate significantly, while bonds have modest gains.

• Stocks grow to: $80,000
• Bonds grow to: $42,000
• Total Portfolio: $122,000

Now, her portfolio's current allocation is:

• Stocks: $80,000 / $122,000 = 65.57%
• Bonds: $42,000 / $122,000 = 34.43%

Her portfolio has drifted from her 60/40 target. To rebalance, Sarah calculates her desired new values based on her current total portfolio value:

• Desired Stocks: 60% of $122,000 = $73,200
• Desired Bonds: 40% of $122,000 = $48,800

To achieve this, she sells $80,000 - $73,200 = $6,800 worth of stocks and uses those proceeds to buy $48,800 - $42,000 = $6,800 worth of bonds. This brings her portfolio back to the 60% stock, 40% bond target allocation. This process helps her manage drawdowns by systematically reducing exposure to overperforming assets and increasing exposure to underperforming ones.

Practical Applications

Time-based rebalancing is a widely used strategy in portfolio rebalancing across various investment contexts:

• Retirement Accounts: Many investors apply time-based rebalancing to tax-advantaged accounts like 401(k)s and IRAs, where transactions do not immediately trigger tax implications.²¹ This makes it simpler to execute on a fixed schedule.
• Target-Date Funds: These popular mutual funds inherently employ a form of time-based rebalancing, automatically adjusting their asset allocation to become more conservative as the target retirement date approaches.
• Advisory Services: Many robo-advisors and traditional financial advisors implement time-based rebalancing for clients, automating the process to ensure portfolios remain aligned with stated goals and risk profiles.
• Institutional Investing: Large pension funds, endowments, and other institutional investors often adopt periodic rebalancing due to its systematic nature and ease of implementation.
• Risk Management: The primary application is to manage risk. By regularly selling appreciated assets and buying depreciated ones, investors prevent their portfolio's risk level from drifting too high (if equities outperform) or too low (if bonds outperform). Vanguard highlights that rebalancing helps investors maintain their desired risk levels and avoid making costly mistakes by sticking to a disciplined strategy.²⁰,¹⁹

When considering practical applications, investors should be mindful of associated costs, such as brokerage fees or the expense ratio of funds.¹⁸

Limitations and Criticisms

While time-based rebalancing offers discipline, it has limitations and faces criticisms:

• Missing Momentum: By strictly adhering to a schedule, time-based rebalancing can force investors to sell assets that are experiencing positive momentum and buy those that are declining, potentially hindering higher returns if market trends persist. Some research suggests that more frequent rebalancing, or rebalancing based on thresholds rather than time, might not significantly improve risk reduction or returns and can increase transaction costs.¹⁷,¹⁶
• Transaction Costs: Frequent rebalancing, even if time-based, can lead to increased brokerage commissions or trading fees, especially for active traders or portfolios with many holdings.¹⁵
• Tax Inefficiency: In taxable accounts, selling appreciated assets to rebalance can trigger capital gains taxes. This can reduce the overall after-tax return, making the strategy less efficient compared to rebalancing in tax-advantaged accounts or using tax-loss harvesting.¹⁴,¹³,¹²
• Ignoring Market Conditions: A key criticism is that time-based rebalancing is agnostic to market conditions. It mandates rebalancing even if markets are highly volatile or if the portfolio's deviation is minimal, which might not be the most opportune moment.¹¹
• Suboptimal Returns: Some argue that in strong, persistent bull markets, periodic rebalancing can lead to lower long-term returns compared to a "buy-and-hold" strategy, as it forces the sale of winning assets prematurely.¹⁰,⁹

Time-Based Rebalancing vs. Threshold Rebalancing

Time-based rebalancing and threshold rebalancing are two common strategies for maintaining a portfolio's target asset allocation, but they differ in their triggers.

While time-based rebalancing offers simplicity and behavioral benefits by automating the decision, threshold rebalancing attempts to be more efficient by only acting when a material deviation occurs. Some strategies even combine both, for instance, reviewing annually but only rebalancing if a certain threshold is met.⁸

FAQs

How often should I rebalance my portfolio using a time-based approach?

Common frequencies for time-based rebalancing include annually or semi-annually. For most broadly diversified stock and bond portfolios, annual or semi-annual monitoring with rebalancing at specific thresholds (if combined) is often suggested as a reasonable balance between risk control and cost minimization.⁷ More frequent rebalancing, such as monthly, may lead to higher transaction costs and can sometimes stifle returns.⁶

Does time-based rebalancing guarantee higher returns?

No, time-based rebalancing does not guarantee higher returns. Its primary purpose is to manage the risk tolerance of a portfolio and keep it aligned with its long-term asset allocation. In certain market conditions, a "buy and hold" strategy, especially in a sustained bull market, might outperform a rebalanced portfolio.⁵ However, rebalancing aims to prevent the portfolio from becoming overly concentrated in risky assets, which helps protect against significant drawdowns during market downturns.

What are the tax implications of time-based rebalancing in a taxable account?

When you sell appreciated assets in a taxable brokerage account during rebalancing, you may realize capital gains, which are subject to taxation.⁴,³ If you hold an asset for less than a year, the gain is considered a short-term capital gain and is taxed at your ordinary income tax rate. If held for more than a year, it's a long-term capital gain, typically taxed at lower rates.² To mitigate this, some investors use tax-loss harvesting or conduct rebalancing within tax-advantaged accounts where transactions do not trigger immediate taxes.¹

Is time-based rebalancing suitable for all investors?

Time-based rebalancing can be suitable for many investors due to its simplicity and disciplined nature. It helps maintain a consistent risk profile over time. However, investors with very small portfolios, those with extremely low risk tolerance that might require more frequent checks, or those looking to actively exploit market movements might find other rebalancing strategies or a combination of strategies more fitting. Always consider your individual circumstances and investment objectives.