August 5, 2020
In the 3+ years, while working on the Safe Withdrawal Rate Series, I regularly get this question:
What’s my assumption for rebalancing the portfolio?
In the simulations throughout the entire series, I’ve always assumed that the investor rebalances the portfolio every month back to the target weights. And those target weights can be fixed, for example, 60% stocks and 40% bonds, or they can be moving targets like in a glidepath scenario (see Part 19 and Part 20).
In fact, assuming monthly rebalancing is the numerically most convenient assumption. I would never have to keep track of the various individual portfolio positions (stocks, bonds, cash, gold, etc.) over time, but only the aggregate portfolio value. If the portfolio is rebalanced back to the target weights every month I can simply track the portfolio value over time by applying the weighted asset return every month.
But there are some obstacles to rebalancing every single month:
- It’s might be too much work. Maybe not necessarily the trading itself but keeping track of the different accounts and calculating the aggregate stock and bond weights, potentially making adjustments for taxable accounts, tax-free and tax-deferred accounts, etc.
- It might involve transaction costs. Even in today’s world with zero commission trades for ETFs, you’d still have to bear the cost of the bid-ask spreads every time you trade.
- Even if you hold your assets in mutual funds (no explicit trading costs) there might be short-term trading restrictions prohibited you from selling and then buying (or vice versa) too frequently.
- It might be tax-inefficient. If an asset has appreciated too much you might have to sell more of it than your current retirement budget to bring the asset weight back to target. But that would mean you’ll have an unnecessarily high tax bill that year. Of course, this tax issue could be avoided by doing the rebalancing trades in the tax-advantaged accounts, not in the taxable brokerage accounts.
And finally and maybe most importantly, there might be a rationale for less-than-monthly rebalancing: it might have an impact on your Sequence of Return Risk. So, especially that last point piqued my interest because anything that might impact the safety of my withdrawal strategy is worth studying.
So, on the menu today are the following questions:
- Under what conditions will less-frequent rebalancing do better or worse than monthly rebalancing and why?
- How much of a difference would it make if we were to rebalance our portfolio less frequently?
- Could the “right” rebalance strategy solve or at least alleviate the Sequence Risk problem?