Rebalancing – The 5/25 Rule – The White Coat Investor – Investing & Personal Finance for Doctors

[Update 2020: Over the last year or two we’ve been updating a lot of our classic posts that regular readers have never seen. Jill, our content manager, is in charge of selecting them (along with guest posts and the Saturday WCI Network posts). When she saw this one she said, “It’s cool to see your investing strategy hasn’t changed since 2011.” Little did she know, it hasn’t changed since 2004. I guess it’s kind of boring to buy, hold, and rebalance a fixed asset allocation of low-cost, broadly diversified index funds. But it is effective. Fund it adequately and it’ll get you to your goals with a minimum of risk and very little effort. Today, we’ll hit that third part–rebalancing. Be sure to include a line about rebalancing in your written investing plan. No written investing plan? You’re not alone (see the poll below), but you’ll do better if you get one.]

My long-time readers (as if there are any on a 3-month-old blog) know that I am an advocate for a low-cost, buy-and-hold, static-asset-allocation portfolio. A key component of a “static asset allocation” is that in order to keep it “static” you must occasionally rebalance back to the desired allocation. A portfolio that is 50% stocks and 50% bonds has a different expected return and level of risk than a 75/25 portfolio.

Two Major Schools of Thought on Rebalancing

Rebalancing on a Set Time Interval

The first is that you rebalance on a set time interval. Some portfolios, most famously Yale’s Endowment Portfolio, are rebalanced on a daily basis. However, studies seem to indicate that you don’t want to rebalance much more often than once a year, and that every 2 or 3 years is probably fine due to momentum in the market.

So, to keep things simple, many investors simply rebalance on an arbitrary date each year, perhaps December 31st, perhaps their birthday, perhaps tax day.

I help my parents with their portfolio, and they rebalance each March. I’m amazed at how well that has worked out for them the last few years. They ended up rebalancing into stocks at the perfect time in 2009. At a time when many others were fearful to put money into the stock market, they did so simply because that was the investment plan, no emotion involved. They also avoided “catching a falling knife” (like I did using the 5/25 rule) as the market went down, down, down in the Fall of 2008.

Rebalancing with the 5/25 Rule

The second school of thought is to follow the 5/25 rule.  This rule has you rebalance using bands.  The downside to this is you actually have to pay some attention to the market occasionally to know if you’ve gone outside your bands.  The upside is that it ensures your asset allocation stays within bounds that you set.

What Does the “5” Mean?

The “5” portion of the rule means that if an asset allocation deviates by an absolute percentage of 5% of the portfolio then you rebalance it.  This refers to the big blocks in your portfolio.  For example, if your portfolio calls for 30% international stocks you’ll rebalance when that percentage hits either 35% (selling some) or 25% (buying some more.)

It may also refer to the overall stock:bond ratio.  For example, a 50% stock portfolio may need to be rebalanced if it becomes a 45% stock portfolio, even if none of the individual stock asset classes have fallen enough to justify a rebalancing event.  For example, a portfolio that is 25% US stocks and 25% international stocks where both components have fallen to 22.5% of the portfolio.

What Does the “25” Mean?

The “25” portion of the rule refers to the smaller asset classes in the portfolio, for example, those chunks that may make up only 5-10% of the portfolio.  This refers to a change in the asset class that is a relative 25% of that asset class.  If your asset allocation calls for a 10% allocation to gold, for instance, then you would rebalance when it hit 12.5% (sell) or 7.5% (buy).  Likewise, a 5% position to emerging market stocks would be rebalanced at 3.75% and 6.25%.

Rebalancing Using New Money

Many young accumulating investors (read, small portfolio relative to annual contributions) are usually able to rebalance using new money.  I simply direct my contributions to the asset class that is lagging.  It takes a major market movement for me to need to sell anything even using the 5/25 rule.

Rebalancing to Minimize Taxes

It is also wise to avoid accumulating unwanted taxes by rebalancing.  If you’re careful, you can rebalance while eliminating or at least minimizing taxes by following these steps:

1. Direct new contributions to lagging asset classes.
2. Don’t reinvest dividends/capital gains distributions in a taxable account.  Direct these to lagging asset classes.
3. In a taxable account, sell investments with a capital loss.  This doesn’t happen often, as you usually need to buy more of the classes that have recently performed poorly, but through careful tax-loss harvesting, you can often sell some losing investments to cancel out some or all of the capital gains you may generate through rebalancing.
4. Try to do all or most of the necessary selling in a tax-protected account.  Although commissions or fees may be generated (hopefully not), there are no taxes due from buying and selling in a Roth IRA, 401K, or similar accounts.
5. When selling investments in a taxable account, consider less frequent rebalancing intervals, perhaps even every two years.  Also, only sell investments with a long-term capital gain (one year) rather than a short-term capital gain.

Be careful not to let the tax tail wag the investing dog, but keeping expenses, including taxes, down is an important part of investing.  Investing, more than anything else is about managing risk.  Rebalancing is an important risk management tool.  When markets trend down like they have recently, you should always consider if it is time to rebalance (as well as tax-loss harvest.)