Hi. I'm Mohneet Dhir. Hi. I'm Andreas Zingg. Today in this video, we explore the importance and the application of portfolio rebalancing strategies. Money. Mohneet, what is portfolio rebalancing? Portfolio rebalancing is a process of selling your best performing securities within your portfolios and using the profits to buy poorer performing securities, if you will. That doesn't sound intuitive. If I may, to sell the best performers and to buy the stocks or the securities with low performance.
Yeah, I know, rebalancing does seem counterintuitive when you look at the actual description. However, without rebalancing most portfolios, all portfolios, in fact, would drift over time as markets move. For example, if we look at a 60% equity, 40% bond portfolio, in 2003. So let's assume the equity asset allocation was 60% in 2003, if you didn't rebalance from then up until 2021, your equity allocation would jump from 60% to 80%.
Just purely market movement. And that's no rebalancing. So that's just additional risk that investors are taking. And I think it's important to remember that the goal of rebalancing is not to optimise gains, it's to manage risk within portfolios. Okay. So what are the common kind of practices? What are the approaches to rebalancing? Yeah, so there's a couple of different approaches that people tend to use.
The first one is time-only, which essentially means that you set a schedule and you rebalance on that schedule, whether that's daily, weekly, quarterly, semiannual, or annual, which means that on that set frequency, you will rebalance regardless of whether you're getting cash flows or regardless of how far your portfolio has drifted. The second approach is by using thresholds-only, which means that you set a threshold and you say, ‘If my portfolio, if my exposure to equities moves from 60% by 1% so to 61 or 59, I will rebalance my portfolio back to 60.’
That's your threshold-only approach. The third approach is combining the two of these. So on your set time schedule to say, for example, you rebalance on a daily basis, every day you would check, ‘Okay, it's my time to rebalance’, but then you also have a threshold approach built within that, that if my portfolio moved by 1%, I would check on a daily basis and then rebalance it back to 60%.
We will probably rebalance less frequent than on a daily basis. So you have described the three approaches. Which one is the best? Actually, the research shows that there's no particular advantage with one or the other. What matters is that you pick an approach that works for you and your portfolios and you stick to it over the long term.
That is the most important part. Again, sort of coming back to my earlier point, it's about managing risk, not maximising gains. So I'm sure like the advisors can talk to the client and figure out which one fits best to the preferences of the clients, but it's important that the portfolios are rebalanced. Yeah. Are there some kind of rule of thumb that we could recommend to the advisor? Some practices that they could apply when they rebalance?
Absolutely. So the first one I would say is being mindful when you rebalancing and using cash flows where you can. If you get say, net inflows on a daily basis, what you can do with those inflows is that you buy the underweight securities or the underweight allocations first. You allocate them there so you don't have a need to sell existing allocation in order to take them back to target weight.
If you have outflows, you can use the overweight securities first and actually take money out of those first to fund the outflows. So that's the first point, using cash flows where you can, that will help. And it nicely takes me on to my second point, it will also help minimise costs because you minimise transaction costs by doing that as well.
Transaction costs are quite important because when you, for example, if an investor has, when they're thinking about thresholds, often rather than say, for example, your portfolio drifts from 60 to 61%, if the investor can tolerate 60.5%, that can help limit transaction costs rather than doing the whole one percentage point. The third one is thinking about it from a tax perspective going for the tax advantaged account first, which obviously lowers your tax burden when it comes to thinking about rebalancing.
So those three points I think are really important. And if investors think about those when they're rebalancing and making sure that they stick to the rebalancing approach that they've taken as overall, whether it’s time threshold or both, that's the most important thing. Thank you. I should probably add here that all Vanguard multi-asset solutions, be it funds, ETFs or model portfolios, are rebalanced on a regular basis following exactly the rules you just described to give the best chance for investment success to our investors.
We hope you found this video helpful. Thank you and goodbye.
