Portfolio Rebalancing and Asset Allocation

I just came accross an article on The Motley Fool titled "Get Smart about Asset Allocation" that is a very nice followup to my post yesterday about dollar cost averaging. They quote an AllianceBernstein survey which estimates that if people re-balanced their portfolios correctly they would add an additional 1.64% per year to their returns. Over the past 30 years that would be an additional 68% return. Not bad for just moving money around in funds/stocks that you already own. This is of course predicated upon a solid initial allocation that you are re-balancing.

Why would this work? Well, assuming that there are non-rational periods of stocks being over valued and under-valued, this is a way of taking money from your assets that are overvalued and buying those that are undervalued. Problem is, there is no way to know when your investments are over-valued and under valued. But, by re-balancing you have a pretty good chance of moving your money from a sector that is over valued to one that is undervalued. 1.64%, and missing market slumps. Not bad.

What is infrequently mentioned is that Proper Allocation Strategywill depend in very large part on 1) if you are investing in a tax advantaged account, and 2) transaction fees. Those damned taxes and transaction fees that always mess up our assumptions of a perfect, frictionless financial market. And unfortunately are usually glossed over by most personal finance articles on the subject (granted taxes less so). If you are a small investor who pays transaction fees to sell stocks or funds and to re-invest then you will likely be better off waiting longer than larger investors to rebalance.

Consider the following example.

You invest $1,000 each in stocks ABC and XYZ in 2005. In 2007 ABC has trippled in value over the time while XYZ has largely stayed flat. In 2007 you still like both ABC and XYZ, but your assets are largely out of balance. You have $3,000 in ABC and only $1,000 in XYZ but you would like to have equal amounts in both. To rebalance you would sell $1,000 worth of ABC to buy $1,000 worth of XYZ. In doing so you're likely to trigger $30 in transaction costs (assuming you pay $15 per transaction - I pay $12.99 with e*trade). Or, you'll be paying .75% of your portfolio in the transaction costs. Assuming you will make the 1.68% gain by rebalancing, then you're still .93% ahead this year and further next year.

Now, this is where tax advantaged (read IRAs) vs. normal brokerage accounts are going to make the biggest difference. To sell $1,000 ABC you'd have a long term capital gain of $666 for the sale making you liable for up to $100 in taxes (at 15% long term gains tax rate - cap gains calculator, intro article, another intro to cap gains) in addition to the $30 in transaction costs. That takes the cost of rebalancing up to 3.25% just about two years worth of rebalancing gains.

However, if you were adding to your investments steadily over time (dollar cost averaging ideally, even better if you use a payroll or automatic withdrawl to force yourself to pay yourself first) you could decrease the cost of rebalancing by practicing a strategy I call "looser gets attention." This means that you quarterly contribute a set amount of money to either A) the part of your portfolio that has performed the worst over the past quarter - "looser gets attention" or B) the part of your portfolio that is most under represented because it has not performed as well as the others - "total looser gets attention." Say you are contributing $1,000 a quarter to your fund - this would still keep the cost of a stock transaction at $30 to bring your portfolio into balance if you did it over two quarters, or $15 if you did it over one quarter. Saving you the $100 in taxes, plus you would have to pay those transaction costs to buy any other stock so your stock opportunity cost is actually 0.

This works even better if you invest in no-load, no-transaction fee funds. Aside from the 3 month minimum holding to avoid a 2% charge that most funds use to discourage market timing you won't be paying any transaction fees. You may, however, still trigger capital gains if the investments aren't in a tax advantaged account.

Thus a few simple rules:
When you can, rebalance with additional investments. Especially if it is a taxable account.
Rebalance in your IRA as much as possible.
Don't do it too frequently - there can be taxes, fees, and you could sell rising stocks to quickly.

When you are rebalancing it is helpfull to ask the following questions:
What will my tax liabilities be if I do this?
What will the transaction costs be?
Can I rebalance in a tax advantaged account instead?