Rebalancing With New Cash

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.

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Comments

  1. Jay Muntz says

    Edleson does talk about the “no sell” strategy in his book. It results in a slightly lower overall return but it has all of the advantages you state.

    I don’t think this strategy can completely replace periodic rebalancing. As your portfolio grows over time, your monthly contributions will become too small relative to the size of your portfolio to have any real affect on your asset allocation. You’ll still need to rebalance if you ever want to get back to your target allocation.

    As an example, during the late 1990s a strategy of “not buying any more stock” would not have been enough to reduce your exposure to stocks. You would have needed to rebalance at some point to avoid becoming completely overweighed in stocks. If you didn’t do it, you would have eventually gotten clobbered.

  2. Ted Valentine says

    I played around yesterday with what Jay was saying.

    Assuming a 10% equity return and 5% fixed income return at 60/40, critical mass would take over a portfolio approximately 16 times income if your investment rate was 20%. But that’s under “normal” conditions.

    Does that number seem about right?

  3. TFB says

    Ted, instead of using a multiple of income and assuming an investment rate, I think it’s easier to use a multiple of new cash. By my calculation, using 10% return for stocks, 5% return for bonds, and 60/40 allocation, as long as the new cash is equal or greater than ~2% of the portfolio size, one can direct all new cash to bonds and maintain the 60/40 allocation without having to sell stocks. That’s a 50x multiple over new contributions.

    For a couple contributing the maximum to 2 401k’s and 2 IRAs, the portfolio size has to be over $2 million before it overwhelms the contributions.

    This has not become a problem for me yet. It will be a good problem to have though, because it means the portfolio has reached a decent size.

  4. Jay Muntz says

    My hunch is that you’re going to run into this sooner than you think. I just think it’s pretty easy to imagine that your 60/40 allocation becomes 85/15 because of market moves, and you find that your monthly contribution only improves this to 83/17, or something. Then, you may start worrying about it.

    You could also divert your distributions to the underweighted asset class. In other words, divert the distributions from your stock fund to the bond fund or vice versa.

  5. KD says

    I just wanted to let you know that I followed this to the T when I invested my new cash in CDs to rebalance my allocation and bring up the fixed income part to the level I desire. Thank you for all your helpful articles.

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