Rebalancing Results for an Index Fund Portfolio

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Includes: HYG, IWM, SPY, TLT
by: Zach Tripp

I would like to discuss my rebalancing strategy for my daughter’s 529 index fund portfolio. Rebalancing is when you return your portfolio back to the original or desired asset allocation. Typically, one or two holdings will outperform the other holdings, which means the outperforming holdings eventually will represent a larger percentage of the total portfolio than they originally did.

I see the primary purpose of rebalancing as to keep the risk profile of your portfolio the same. My daughter’s 529 index fund portfolio has an asset allocation of 70% stocks and 30% bonds. If one fund becomes greater than 5% of its original allocation for two straight months, I will rebalance the entire portfolio back to its original allocation.

In this blog, I will share the results of my back-testing of this approach. All data is from Yahoo! Finance. I used the adjusted closing price. The adjusted closing price, available for the requested day, week, or month, takes into account all applicable splits and dividend distributions. I used the adjusted closing price for the purpose of this analysis because I wanted to ensure it included dividends. This back-testing does assume you can rebalance more than once year. Unfortunately, Vanguard only allows rebalancing once a calendar year in an 529 portfolio.

I looked at the period from July 1996 to July 2010. July 1996 is the furthest back one of the five funds has data for in Yahoo! Finance. Fourteen years is not a typical period, but it served the purpose. It included the tail end of the dot-com bubble, the dot-com crash, the 9-11 stock market decline, the housing bubble, the corresponding stock market bull market, the financial market crash, and finally, the bull market from the recovery.

The graph below shows the performance of each individual fund (High-Yield Corporate, Small-Cap Index, Total Bond Index, Total Stock Market Index, Total International Stock Index).

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The graph below represents the performance of a 70% stock / 30% bond portfolio. It assumes a $3,000 initial investment. Again, performance is with dividends reinvested.

Portfolio:

  • Total International Stock Market Index = 40%
  • Total Stock Market Index = 15%
  • Small-Cap Index = 15%
  • Total Bond Index = 15%
  • High-Yield Corporate = 15%

If one fund grew to more than 5% for two straight months, I would have rebalanced the portfolio back to its original allocation, keeping the overall risk profile the same. The performance would have actually increased from 5.575% average annual return (without rebalancing) to 6.160% average annual return with rebalancing. July 1996 to July 2003 had essentially the same return and variation in portfolio value. Between July 2007 and January 2009, the rebalanced portfolio lost 43% ($8,208 to $4,685), compared with 45% for the non-rebalanced portfolio ($7,909 to $4,367).

Rebalancing my portfolio when one fund grew more than 5% from its target allocation for two straight months increased the average rate of return and had less of a percentage decrease during the 2008-2009 stock market bear market.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.