Rebalancing: Percents That Pay

This information has been moved to an updated article on the Investing tab. Click here to go to the full article, which covers these topics:

1. Income Placement: A simple idea that greatly reduces the need for you to rebalance your portfolio.
2. Percent Triggers: An excellent strategy that precious few investment firms offer. How it works and where you can find it. It's the topic of this post.
3. Calendar Triggers: A common strategy that's less effective than you may think. Evidence that monthly, quarterly and yearly rebalancing are over-rated.
4. Compound Triggers: How to get the best combination of calendar and percent triggers, particularly if you intend to do your own rebalancing. Getting better returns with less work.
5. Cash Flow: A neglected topic that affects your rebalancing strategy if you are making regular deposits or withdrawals.
6. Practical Advice: A summary of the best options to rebalance in ways that will work for you. Serious talk about whether the price you pay for rebalancing is worth the benefit you may get.

Percent Triggers: What Are They?

In the first post of this series, I reported that a simple strategy of income placement may produce better returns than ordinary rebalancing. To do income placement, you direct your dividends, interest, and new income toward parts of your portfolio that are below-target. For example, if you intend to be 40% invested in stocks, but are currently at 43% because of market drift, put your stock dividends and other income into your bond funds.

Is that enough? Should you also, under some circumstances, rebalance your portfolio to restore your target allocations? Intuition would suggest that if your portfolio is way off-target, you should take some action to get back on plan.  A percent trigger is one way to do it. The idea is simple enough. Set a trigger at a certain percentage. When your portfolio drifts out-of-balance past that percentage, rebalance your portfolio.

Here's an example. You have three funds in your portfolio, which you want to be distributed 40% to U.S. stocks, 20% to international stocks, and 40% to U.S. bonds. Your portfolio happens to be at 43% U.S. stocks, 15% international stocks, and 42% U.S. bonds. Checking whether it's time to rebalance, you first find the funds that are higher than their targets, and add up their surplus percentages; you ignore the funds that are below their targets. In this case, U.S. stocks are 3% too high, and U.S. bonds 2% too high, for a total of 5%. If your trigger is 5% or less, it's time to rebalance. If your trigger is, say, 10% (or any number bigger than 5%), sit tight; don't rebalance at this time.

Is 5% a good threshold? Or would 10% be better? Or maybe 1%? To investigate, I studied the same five portfolios described in the previous post, across stock-allocations of 20%, 40%, 50%, 60% and 80%. For these portfolios, historically, the data gave a clear and consistent answer. The chart below shows the main finding.

The chart says that the best percent trigger for these particular portfolios and stock-allocations was around 3% to 4%, on average. As shown by the green line, portfolios rebalanced after drifting 3-4% had annual returns that were 1% better than income placement, overall. The orange and blue lines in the chart show what happened in the best cases (90th centile) and worst cases (10th centile) of the portfolios and allocation levels I studied. Recall from the first post in this series that income placement by itself created its own incremental benefit over quarterly or annual rebalancing. Thus, the combined benefit of income placement plus a percent trigger of 3-4% produced an extra 1.25% to 1.50% per year. Not bad!

As reported in the earlier post, income placement by itself has a bias toward stocks, particularly in portfolios with a low allocation to stocks. Percent triggers nearly eliminated the bias. In the worst case of portfolios with a 20% stock-allocation, percent triggers that improved returns also reduced the bias to 0.8% on average (20.8% invested in stocks instead of the target 20%).

For more results, and to find firms that will do this type of rebalancing for you, click the "read more" link ...

Percent Triggers: Do They Always Work?

Clearly, even in the chart above, rebalancing on a percent trigger is not universally advantageous. Triggers set below 1% do more harm than good, slashing returns compared to income placement. These hair-triggers fire too often, buying more stocks as they are starting to fall or selling them just when they begin to rise. At the other extreme, lazy triggers of 15% or more fire so rarely that they neither help nor hurt.

What about different allocation levels? Does the sweet-spot of 3-4% work equally well no matter how high or low the stock-allocation may be? As shown in the next chart, the answer (in these portfolios, historically) is yes, with two caveats:

• For a low allocation to stocks (the 20% level in blue on the chart) no percent trigger has much impact on the returns generated by income placement.
• The benefits increased at higher stock-allocations, and as the benefit grew, the sweet-spot tended to shift a bit higher. Depending on the allocation, the sweet-spot fell somewhere between 2% and 5%.

And for different portfolios and timeframes? Did they all exhibit the same patterns? The next chart has the answer. Yes, across portfolios, percent triggers of 2% to 5% improved returns over income placement, by about 1% per year.

Perhaps you noticed that the chart above only shows four of the five portfolios I constructed for this study. Not included is Shiller's long-term portfolio of U.S. stocks and bonds from 1871. The reason is that the data from 1871 is monthly; for the other portfolios, the data is weekly. It matters, because percent triggers work best when you check them frequently. Gobind Daryanani reported this finding in a 2008 study, where he systematically evaluated daily, weekly, and longer periods of checking a variety of percent triggers. In my data, the monthly data from 1871 had a sweet-spot at 3%, but because the trigger was checked less frequently, the benefit was limited to a smaller incremental return of 0.2% annually.

This limitation is important. For percent triggers to generate their full value, you must check them at least weekly. They won't fire often, typically 3 or 4 times a year for a 2% trigger or less than once a year at 5%. If you check them less than weekly, the benefits to your portfolio's returns will be diminished.

For this reason, percent triggers are best left to computers that can run an algorithm daily or weekly, and either rebalance your portfolio automatically or alert you to do so.

Percent Triggers: Where Can You Get Them?

If you prefer to do your own rebalancing, you may want to consider other methods of rebalancing that I'll detail in future posts. However, if you are willing to let a firm's computers do your rebalancing automatically, read on.

I've investigated firms whose retail websites claim they do automated rebalancing, including the full list of firms identified recently by the New York Times. Only three firms provide a combination of income placement plus percent-trigger rebalancing at a reasonable price. My benchmark for reasonableness is that the firm's total fees for rebalancing plus embedded fund or ETF fees plus anything else they automatically charge is 0.4% ($4 per $1000 per year) or darn close. In rank order, best first, the three firms are:

1. Betterment. Their model fits the findings of this study perfectly. It's completely automated and tax-aware. It works on fractional shares, so you get the full benefit no matter the size of your account.
2. Wealthfront. Their model also fits well and is tax-aware , although they don't publicize the percent level at which they trigger rebalancing. Also, they don't do fractional shares, and they maintain a small cash balance in your account, so the benefits may be slightly diminished, particularly for small accounts.
3. SigFig. They do percent triggers, but don't publicize the level. It is not clear from their website whether they do income placement or would have you do it yourself. It's definitely possible to do income placement because they manage ETFs in your own brokerage account at Schwab, Fidelity, or TD Ameritrade.

Disclosure: Historical data does not guarantee future returns; your results may differ. I have a personal account at Betterment, but receive no compensation of any kind from them or from any other firm mentioned here. None of the information here should be taken as advice or solicitation to buy a particular fund, security, product, annuity, or type of insurance. You are responsible for your investment decisions, and should read the prospectus and disclosures for a security before investing. Investments have risks; you may lose money. Able to Pay LLC is not a tax advisor. Consult the IRS or your tax adviser about tax consequences. Please read our full disclosures and our Fiduciary Oath.

Technical Notes

For those interested in the technical details, a list of key points follows. In another forum, I'll provide a complete write-up of all my research on rebalancing, including the methods of obtaining and analyzing the data.

• Percent triggers were evaluated at intervals of 0.5% from 0.5% to 10%, and at 15%, 20% and 25%.
• All averages are geometric means.
• Data on the chart were smoothed statistically to make the charts easier to read.
• Tests of statistical significance were not done, because it is questionable that they would satisfy the presumption of a random sample.
• The datasets make it possible to calculate total return when neither income placement nor rebalancing is done. Many studies have used this value as a baseline for judging the benefit of rebalancing. I have eschewed using that value because over very long periods, it has a strong bias, drifting toward stocks and inflating baseline returns. I believe it is more informative to use income placement as a baseline, since one must do something with dividends and interest, or to compare common strategies of quarterly or yearly rebalancing against other methods.