Rebalancing Your ETF Portfolio

By: Pete
Date posted: 04.22.2012 (9:38 pm) | Write a Comment  (0 Comments)

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I know, I know, rebalancing your portfolio probably sounds like the worst part of the whole project and is one of the reasons why many investors never get started building their own portfolio, despite all of the benefits. Let me start off by saying: It’s not as bas as it sounds!! Today, I decided a deeper look into the process, why it matters and why it should not stop you.

What Is A Portfolio Rebalancing?

When you start building your ETF portfolio, the most critical part is finding your target asset allocation. That is by far the most important aspect of any portfolio and will end up explaining the returns of your portfolio. That process is done every year. Why? No one expects big changes apart from those created by a good event (inheritance, promotion, etc) or a bad one (losing your job, etc). Even without significant changes, your target asset allocation is likely to shift. The more you need your money (older age, losses in the market, etc), the more you will perhaps want to be safe with your investments. In the end, you should have at all times an updated target asset allocation for your portfolio.

However, your portfolio will NEVER represent exactly that allocation. Why? Because markets change and because you want to avoid trading unnecessarily in order to avoid excessive trading costs. However, from time to time, you will have the opportunity to get your portfolio as close as possible to the target weights.

How Is It Done?

As we had discussed, you should have clear rules about rebalancing. The easiest one is simply to use a fixed rule such as:

-A given amount of money to invest
-A time of the year (quarterly perhaps)

What would you do? Firstly, you would write down what you do own. How much % of your portfolio is currently invested into each asset class and how much is it off from your target weighting? Personally, I like to use a 5% rule. If you have any investments that have 5% over what they should, you should prepare to sell part of that position to get it back in line.

The next step is to use the cash that you have to buy asset classes that are under-invested. Anything that is 5% or less under its target must be corrected. As for other ones, do them on a best effort basis. I would not personally do a trade for under $1000 or even $2000.

Stick To The Rules

I can tell you right now, you will have many different temptations when working on the rebalancing process. First off, you have gut feelings about the market, thinking that It is going to rise or that specific asset classes will do better than others. That might be accurate or it might not be. The point anyway is that this is passive index investing and should not try to reflect your views or opinions. You are doing this method of trading specifically because over time it performs incredibly well. The moment you start putting your feelings, judgments and opinions into it, it is no longer passive investing.

One Slip Is One Too Many

The problem of course is once you start “bending” the rules, there’s no stopping. Think about anyone on a diet that decides to take just a few chips or a smoker that takes “just” one cigarette. How well does that usually work out? I would argue not too well. It’s critical for this to work to be disciplined and stick to the plan. There are reasons why you could be late for a rebalancing, such as being on vacations. But there should not be a reason to over or under invest in either portfolio or one specific asset class without first updating your target asset allocation.


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