More changes! Testing New Rebalancing Rules

I changed the composition of portfolios recently to reflect new learning about better choices for some asset classes. In the same spirit, after reviewing the Kitces paper recently, I’m adding rebalancing rules to two test portfolios to see what kind of difference they make.

Short post, just to announce some small additions to the test portfolio series. I track 11 portfolios in total: 3 original, 2 old-school Risk Parity portfolios, three “new school” leveraged Risk Parity portfolios, and 3 benchmark portfolios, and if you’ve been following the blog, hopefully you’ve seen how they’ve performed since inception in July 2021. If not, you can find the latest monthly portfolio review here, and you can also check out the test portfolios homepage for all the details.

One conscious choice I made with them was to go easy on portfolio rebalancing, in order to replicate the simple management approach I hope to have in retirement. I am rebalancing them in the most laziest way possible every month - I withdraw about $3500 or so every month for living expenses. I take this money from the one or two assets doing the best, which helps to keep the portfolios more or less close to their target allocations. I don’t do what rebalancing usually does: sell off higher assets and purchase underperforming ones.

It is time to add a bit of complexity, though, and create a way to undertake more substantial rebalancing beyond the monthly withdrawals. For one, simply withdrawing hasn’t quite been enough, as the volatile months we’ve had have twisted the portfolios around a bit. Even the RPC Stability portfolio, the calmest one I have, has assets that are 40, 24 and 22% away (in relative terms) from their target allocations. As for the RPC Growth portfolio, my most volatile, it’s almost unrecognizable. It has assets 69, 57, 55 and 111% (!) away from the proportions I’d like them to be in.

Secondly, my recent review of Michael Kitces’s great paper on rebalancing strategies turned up a research nugget from Gobind Daryanani that just can’t be ignored. Daryanani suggests that using a 20% threshold, in relative terms, for rebalancing could offer a “rebalancing bonus” of up to .4%. In the quest for the best perpetual withdrawal rates, an extra 40 basis points would matter a lot.

So, I’ll be testing that rebalancing approach by following two more portfolios, or rather, versions of two portfolios to which I’ll add the rebalancing procedures. You can read all the nitty-gritty details below about how I handle some of the subtleties, but basically, I’ll be keeping shadow versions of the RPC Income and RPC Growth portfolios that have the additional rebalancing rules.

The first rebalancing will be around November 1st, and appear in the October portfolio review to be released around that time.

I will update any rebalancing events in the portfolio reviews, if they happen, and plan to write a progress report in January or February to assess the impact of the added rules. For now, I’m just doing this on a limited scale, but if it’s a success, I may adopt these rebalancing for all portfolios at some point in the future.

The Nitty-gritty

First off, all the former rules for withdrawals remain. I will make withdrawals from the assets in the portfolio to satisfy living expenses. If, after those withdrawals, any asset is either 20% above or below its target allocation, those assets will be rebalanced. This is not portfolio-wide rebalancing.

If there is just one asset that has passed the threshold, either above or below, then I will rebalance with the two farthest from ideal on the other side (example: A is +27%, but there are no assets that are more than 20% under. In this case, I’ll balance A with B and C, which are, let’s say, 17% and 15% below their target allocations, respectively). I take from two to spread out the impact for assets that aren't meeting the threshold rule.

To prevent selling too much of an asset and putting it under its allocation going forward, there is a “sell cap” that limits the amount sold to the amount scheduled for purchase. In other words, you take the lower of the two amounts for buy and sell so that you never sell so much to make something that was higher, go under.

Real-life Portfolio Changes Too!

I already follow a threshold rebalancing approach in real life, but with a little stricter tolerance band (10%), so I’m well used to the concept. Now having read Kitces and Daryanani, I’ll be bumping that up to 20% to let the lead horses run a bit more before reigning them in. Lately, of course, that hasn’t been a problem, but still!