Rebalancing your portfolio leads to trading costs. These include brokerage fees when you sell one investment and reinvest in another, bid-ask spreads and taxes on realized capital gains.
Reduce the cost of portfolio re-balancing by tying it to your ordinary investing as you go along.
Rebalancing is a smart investment strategy. It lets you side-step the trap of portfolio drift (where changes in market prices change your asset allocation). Instead, rebalancing keeps your portfolio balanced at your desired asset allocation targets. This should help you sleep at night. Rebalancing also enables you to profit from contrarian investing. But unfortunately, rebalancing is costly.
One cost of rebalancing is that you incur brokerage fees, of course. You pay one fee to sell costly investments and another to buy cheap investments.
Less obvious, you enrich ‘market makers’ through the bid-ask spread. That is, when you sell, you’ll usually receive the lower bid price. When you reinvest, you’ll likely pay the higher ask price. You could hold out for the ask price when you sell and the bid price when you buy. But this is apt to cost you even more in lost investment opportunities. Particularly on the NASDAQ stock exchange.
Keep capital gains working for you
A third cost with rebalancing is the income tax you pay on realized (or taken) capital gains. Since you’re selling investments that have mostly gone up in price, you’ll face taxable capital gains most of the time. The exceptions are when you take profits in tax-deferred accounts such as your Registered Retirement Savings Plan, Registered Retirement Income Fund or Tax-Free Savings Account.
A fourth cost is that you lose the benefit of unrealized gains. Mr. Warren Koontz Jr., vice-president and treasurer of The Jeffrey Company has written: “The value of unrealized gains is often overlooked. Unrealized gains are the portion of a portfolio’s principal growth that has not been realized and diminished by taxes. The longer the gains remain unrealized, the more valuable they are, because deferred taxes on unrealized capital gains compound for the investor instead of Uncle Sam.”
Outside of tax-deferred accounts, keeping unrealized gains means using a buy-and-hold strategy. Critics say ‘frozen’ buy-and-hold portfolios earn lower returns. But the evidence shows that buy-and-hold portfolios usually do better.
Buy-and-hold beats actively-managed
Professors Josef Lakonishok, Andrei Shleifer and Robert W. Vishny examined whether money managers raise the returns of actively-managed funds. They found that on average, buy-and-hold portfolios beat actively-managed ones by 0.78 per cent a year—excluding taxes, management fees and cash holdings (which hurt the returns of actively-managed funds). Professors Lakonishok, Shleifer and Vishny concluded that the trading of active managers hurt the performance of their funds. That’s why unmanaged exchange-traded funds have become so popular.
Still, you can reduce the costs of rebalancing by tying it to your ordinary investing.
This is an edited version of an article that was originally published for subscribers in the December 21, 2018, issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.
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The Investment Reporter •1/16/19 •