This is a continuation of the previous post about my asset allocation.
Portfolio rebalancing is often described as looking at one’s portfolio at the end of the year, selling some winners and buying some losers, so the portfolio goes back to the intended asset allocation. I don’t do that. I don’t sell anything unless I’m trying to simplify my positions.
I rebalance throughout the year with new cash. Because stock funds usually grow faster than bond funds, although my asset allocation is 60% stocks 40% bonds, my new cash is invested about 35% stocks 65% bonds. That way the growth on existing investments plus new cash will maintain the 60/40 ratio.
If stock funds did well in some months, they would get little or no new cash because the investment growth already took care of it. If stock funds did poorly, they would get more or even 100% of the new cash. If stocks funds did really badly, I may even sell some from short-term bonds and buy more stock funds. But if stocks funds did really well, I don’t sell from stock funds. Instead I let the bond funds catch up with new cash.
To express this in math, let
- S be the value of stock funds,
- B be the value of bond funds,
- NC be the value of new cash to be invested,
- R be the ratio of stocks in asset allocation,
- X be the amount from new cash to be invested in stocks
(S + X) / (S + B + NC) = R
Solve for X,
X = R * (S + B + NC) – S
If the calculated X is negative, use 0 and direct all new cash to bonds. If X exceeds NC, get the difference from short-term bonds.
I just discovered that this is a crude form of value averaging. I’ve heard of the book Value Averaging by Michael Edleson, but I’ve never read it. I downloaded the free value averaging spreadsheets. I haven’t had a chance to play with them yet. I think I will do that after I come back from vacation.
Why do I do this instead of the usual once-a-year rebalancing by selling the funds which have grown over their target allocation percentage? Because if I add new cash at the same rate as my target allocation, I will likely have to sell from stock funds at the end of year. It doesn’t make much sense to buy during the year and then turn around and sell at the end of year. That’s going to trigger capital gains and capital gains tax. I’m better off not buying as much in the first place.
Within stocks and bonds, I’m willing to let the relative weights of the sub asset classes vary temporarily. Because I have most of my stock funds in a taxable account, for simplicity of tax lot tracking, I only buy into one stock fund in a month. Whichever fund is farthest from the target allocation percentage gets the new cash for that month. After rotating through the year, they even out. In July, REITs was farthest from the target percentage. So I bought REITs. In August, it was Small Value’s turn. In September, new cash went into bonds because the stock market had good growth.
Questions? Comments? Please let me know.