THE 5%/25% RULE
Rebalancing generally incurs transaction fees, and it may have tax implications. Therefore, it should only be done either when new funds are available for investment or when your asset allocation has shifted substantially out of alignment. I suggest using a 5%/25% rule in an asset class's allocation before rebalancing would be implemented. That is, rebalancing should only occur if the change in an asset class's allocation is greater than either an absolute 5% or 25% of the original percentage allocation.
For example, an asset class was given an allocation of 10%, applying the 5% rule, one would not rebalance unless that asset class's allocation had either risen to 15% (10% + 5%) or fallen to 5% (10%-5%) . Using the 25% rule one would, however, reallocate if it had risen or fallen by just 2.5% (10% x 25%) to either 12.5% (10%+2.5%) or 7.5% (10%-2.5%). In this case, the 25% figure was the governing factor. If one had a 50% asset class allocation, the 5%/25% rule would cause the 5% figure to be the governing factor, since 5% is less than 25% of 50%, which is 12.5%. In other words, one rebalances if either the 5% or the 25% test indicates the need to do so.
The portfolio should undergo the 5%/25% test on a quarterly basis, and the test should be applied at three levels:
· At the broad level of equities and fixed income;
· At the level of domestic and international asset classes;
·At the more narrowly defined individual asset class level (such as emerging markets, real estate, small-cap, value, and so on.)
For example, suppose one had 6 equity asset classes, each with an allocation of 10%, resulting in an equity allocation of 60%. If each equity class appreciated so that it then constituted 11% of the portfolio, no rebalancing would be required if one only looked at the individual asset class level (the 5%/25% rule was not triggered). However, looking at the broader equity class level, one sees that rebalancing is required. With 6 equity asset classes each constituting 11% of the portfolio, the equity asset class as a whole is now at 66%. The equity allocation increasing from 60% to 66% would trigger the 5%/25% rule. The reverse situation may occur, where the broad asset classes remain within guidelines but the individual classes do not. Once again, the 5%/25% test is just a guideline. You can create your own guideline for rebalancing for risk. The discipline that the process provides is far more important than the ratios used.
In summary, rebalancing offers many advantages and is an important part of the investment process.
· It should be performed regularly, using a disciplined approach, such as the 5%/25% rule.
· It should be done whenever new investment dollars are available.
· It adds discipline to the investment process and maintains control of the most important investment decision, asset allocation.
· It allows investors to avoid style drift.
