Last updated: 3 Feb 25 00:10:27 (UTC)

RE-BALANCING: A Free Lunch in Portfolio Management

By Michael Thomas


“Re-balancing means always shopping the sales, automatically.” ―Nick Murray


If an investment is successful, naturally, you’d want to stick with it. The last thing you’d want to do is sell some of your winners to invest more money in your investments that aren’t doing as well. Right?

Well, no.

Unfortunately, human nature’s default investment policy is: let’s sell whatever has performed most poorly over the last block of time so we can buy more of whatever has gone up the most (selling when it’s down and buying when it’s expensive). We intuitively chase immediate past stellar investment performance, which is not, to put it charitably, an optimal long-term strategy.

One of the most powerful and practical antidotes to this counterproductive impulse is: re-balancing.


What is Re-balancing?

Re-balancing is an essential part of managing your investment portfolio by trimming back on winners allowing you to buy more of a laggard, protect your gains, and position your portfolio to benefit from the next uptick in the market. Basically, you are always selling high and buying low.

Suppose your mutual funds are allocated equally among three distinctly different equity sectors: large-company (33%), small-company (33%), and international (34%).

Over the course of a year or two, let’s say, the three sectors will very likely have appreciated differently to a point where they now each represent more or less than the original 33% of your overall portfolio.

The plan is to re-balance the three sectors back to their original percentages. Which means that you will sell off enough of the over-performers to reduce them back down to 33% of the portfolio — and reinvest the proceeds to bring the laggards back up to 33% each.

This rational discipline is the direct opposite of the most basic human instinct.


“Re-balancing is there to save us from ourselves.” ―Nick Murray


Re-balancing causes you regularly to be lightening up on sectors that have become relatively expensive (and thereby potentially more fully valued, if not overvalued) in order to increase your positions in those that have become relatively cheaper (and therefore potentially more attractively priced, as the current market shuns them).

Re-balancing creates a systematic way to buy low and sell high.


An Example

“We sell high for the express purpose of buying low.” ―Nick Murray


Step 1: Invest $36 into Three Mutual Funds, Equally


  • Total shares: 12
  • Value: $36


Step 2: Six Months Later… They’re Out of Balance

  • Fund A grew faster than Funds B and C.
  • Fund B decreased some.
  • Fund C decreased the most.

  • Total shares: 12 (no change)
  • Value: $36 (no change)


Step 3: Re-balance

  • So, let’s re-balance by selling 2 shares of Fund A and use the proceeds to buy shares of Fund B and Fund C.



Step 4: After Re-balancing

By rebalancing your portfolio, you have increased your number of shares from 12 to 20 without adding new money!

If this is done within a tax-advantaged account, such as a 401k, IRA or variable annuity then there are no tax consequences.

  • Total shares: 20 (you increased your shares without adding an money!)
  • Value: $36

“Re-balancing, much like dollar-cost averaging itself, is smarter than we are.” ―Nick Murray


The Benefit

“An annually re-balanced portfolio will outperform the same portfolio without re-balancing.” ―Nick Murray


If you re-balance regularly, it is possible to add an extra 0.3% - 0.5% on top of your returns over the long haul. Generally, the more frequent the re-balancing, the better.

Example: for the years 1968-1991:

rebalancing.jpg

If re-balancing within a tax-shelter (IRAs, 401ks, Variable Annuities) then there are no tax-consequences of trading shares, and many firms have automatic re-balancing programs at no extra cost.


Three Rules of Re-balancing

  1. Only re-balance non-taxable accounts (ie, qualified accounts and variable annuities). Unless it is built-into the investment, such as the American Funds Growth Portfolio (one of my favorites).

  2. Re-balance as often as possible. Example: American Funds allows quarterly, and Jackson variable annuities allows monthly re-balancing.

  3. It’s best to set-up automatic re-balancing. But if you insist on doing so manually, then do so the same day regardless of the market. Don’t turn re-balancing into market timing.


“The most effective tool for overcoming the very human performance-chasing impulse is rebalancing — the act of systematically selling off pieces of overperforming sectors annually re-balanced portfolio will outperform the same portfolio without re-balancing.” ―Nick Murray






About Me

Michael Paulding Thomas

  • Celebrating 35 years in the industry
  • Investment Advisor • Securities Principal
  • Series 6, 26, 63, 65, Life
  • Mutual Funds • IRAs (Roth, Traditional, SEP, Simple, Minor-IRAs) • 529 College Plans • UTMA minor accounts • ABLE accounts • Variable Annuities • 401k Plans • Term Life Insurance • Living Trusts, Land Trusts, LLC’s.




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