Rebalancing Portfolio Threshold Limits

by: Lowell Herr

What is the proper percentage to use as the Threshold Limits or Boundary Targets for rebalancing a portfolio? For example, if we set a target of 15% for an asset class, what upper and lower limits are considered acceptable if the asset class is considered to be in balance? In the ITA Wealth Management portfolios we have gone as high as 35% and as low as 20% for our target limits. Where did those percentages come from? In an 18-year study of eight major asset classes, the greatest return for a portfolio was a 35% threshold if the portfolio was rebalanced once a year. In other words, it made sense to let an asset class run longer than one might expect.

In the investment meeting I recently attended, the issue of rebalancing percentages came up in one discussion. The primary speaker stated that there is no one answer to establishing target limits, or what is called the Threshold in the TLH Spreadsheet. His company uses target limits of 8% or a much lower percentage than what I've been using with the ITA portfolios. Why the large difference?

1) The company using the 8% target limits is evaluating portfolios every day instead of once a year.

2) The company is working with more than eight asset classes.

3) Their research is designed to prevent portfolios from drifting too far away from their target percentages.

In the discussion, the speaker stated that some firms use 10% as the target limits and it would not be a mistake to go as high as 15%, knowing there is such a thing as the "momentum factor" and asset classes will rise and fall for longer periods than we expect. At no time in the discussion did I hear threshold limits running as high as 30% or 35%, the percentages that showed up in the 18-year study.

Now that we have many commission free ETFs (for TD Ameritrade clients) we can keep a tighter reign on our threshold limits without incurring heavy commission costs. For this reason, and based on the research from the company represented by the speaker I heard, I am inclined to reduce the threshold percentage in the TLH Spreadsheet from our higher percentages down to 15% and no higher than 20%.

Another reason for making this move is that I am looking at the portfolios each month, not once a year. By lowering the percentage to 15%, each portfolio should closely track our primary benchmark, the ITA Index.

Example of Threshold Calculation: To make sure every reader knows exactly what I am talking about when I speak of threshold or target limits, here is an example.

Assume we set a target percentage for an asset class of 12% and the threshold or target band is +/- 15%. Then 0.12 x 0.15 = 0.018 or 1.8%. That means the asset class, where the target is 12%, is in balance so long as the percentage does not exceed 12% + 1.8% or 13.8% or drop below 12% - 1.8% or 10.2%.