Rebalancing and Dollar-Cost Averaging

Why a portfolio drifts — and what rebalancing actually buys

An allocation is a decision about risk: how much of the portfolio is in the asset that grows fastest and falls hardest. The decision does not stay made. Because stocks usually compound faster than bonds, a portfolio that is never adjusted slides toward stocks year by year, and the slide compounds. In the simulation in this lesson a 60/40 portfolio left alone is about 66/34 after ten years and about 78/22 after thirty in the median path — and the drift is fastest in exactly the long, good stretches that make investors comfortable with it. What rebalancing buys is the risk level you chose. The simulated portfolios that were reset to 60/40 every year ended thirty years with about the same median balance as the ones left alone — the drifted portfolio owned more of the faster-growing asset, while the rebalanced one kept selling a little high and buying a little low — but the drifted portfolio’s worst single year was worse, and the gap widens the longer it runs. That is the honest summary of the research too: rebalancing can add a small diversification return when assets are volatile and not perfectly correlated, it costs a little when one asset trends for years, and its real job is control. Seen that way, the question is not whether rebalancing pays, but whether the household wants the portfolio it chose or the one the market drifted it into. A retiree whose 60/40 became 80/20 just before a bear market is carrying a risk nobody signed up for, at the moment the balance is largest. A rule decided in advance prevents that without any forecast at all. • Unrebalanced portfolios drift toward the fastest-growing asset — 60/40 → about 78/22 over thirty years (median, in the simulation). • Rebalancing keeps the chosen risk; it is not mainly a return enhancer. • The drifted portfolio’s worst year gets worse with time — and arrives when the balance is largest. $100,000 at 60/40, never rebalanced (simulated, median path) — After 10 years: About 66% stocks · After 30 years: About 78% stocks ← · After 40 years: About 82% stocks · Ending value against an annually rebalanced twin: About the same at 30 years — with a worse worst year

Rebalancing in bands

A target is a range, not a number. Rebalancing on every drift would mean trading constantly, paying spreads and — in a taxable account — creating realised gains, which costs more than the small risk it corrects. The convention that has survived is the **5/25 rule**: rebalance a sleeve when it drifts five percentage points from its target or 25% of it, whichever comes first. On a 70% target, five points is 65–75%; on a 20% target, 25% of it is five points too. Households can also simply look annually, which is enough for most portfolios. The direction is the part that requires discipline rather than arithmetic. Rebalancing sells the asset that has just done well and buys the one that has lagged, so it feels like a mistake at the moment it is executed and it is the only mechanism in the plan that enforces buy-low-sell-high without anybody knowing anything about the future. It is not free money — in a mean-reverting market it adds a little, in a trending one it costs a little, and its real job is risk control: keeping the portfolio at the risk level the household chose. Three implementation rules keep the cost near zero. Rebalance with **new contributions** first, since redirecting money costs nothing. Do it **inside the tax-advantaged accounts**, where a trade has no tax consequence. And use **wide bands** when the account is taxable, because a realised gain is a permanent cost while the drift is usually temporary. None of that requires a forecast, and none of it requires watching the market daily — the opposite, in fact. One year of drift, three points wide — Before: $175,000 equity · $75,000 bonds · $250,000 · After +20% / +2%: $210,000 equity · $76,500 bonds · $286,500 · Equity weight: 73.3% — inside a five-point band · Action: none required · new contributions can go to bonds instead ← The trade is small and the drift is three points, which is why the habit is a glance and a band rather than a monthly event. Doing nothing is a legitimate rebalancing decision.

Writing the rule: calendar, threshold, and the order of operations

There are two simple families of rules and a sensible hybrid. A **calendar** rule rebalances on a date — once a year is enough for most households — whatever has happened. A **threshold** rule rebalances only when a sleeve leaves its band, such as the 5/25 rule on the page before, whenever that happens. The hybrid checks on a calendar and acts only if a band is breached: look every quarter or every year, trade only when needed. Studies of rebalancing frequency have not found a single best schedule; what they find is that very frequent rebalancing adds costs without improving results, and that most of the risk control comes from having a rule at all. The order of operations decides the cost. First, direct **new contributions** to whatever is underweight, which rebalances for free. Second, trade **inside tax-advantaged accounts**, where selling creates no tax. Only then **sell in a taxable account**, and accept the realised gain as the price of staying at the risk you chose. The calculator lab prices that last step: after a year in which stocks rose 25%, restoring 60/40 means selling $7,200 of stock, a fifth of which is gain — $216 of tax at 15% — while $12,000 of new money into bonds would have done the same job for nothing. Write the rule into the plan before it is needed (PF17 builds the full investment policy statement). The rule’s value is that it fires on arithmetic rather than mood: it sells some of what has felt best and buys some of what has felt worst, at exactly the moments that feel least like the right time to do either. • Calendar: rebalance on a date — annually is enough for most. • Threshold: rebalance when a band is breached, such as 5 points or 25% of the target. • Hybrid: check on a schedule, act only outside the band. • Order: new money first, tax-advantaged accounts second, taxable sales last. Three ways to restore 60/40 after stocks +25%, bonds −5% — Redirect new money: $12,000 into bonds — no sale, no tax · Trade inside an IRA or 401(k): Sell $7,200 of stock — no tax ← · Sell in a taxable account: $1,440 of realised gain, $216 of tax at 15%

All at once or a little at a time? Dollar-cost averaging, honestly

Dollar-cost averaging means taking a sum you already have — an inheritance, a bonus, the proceeds of a sale — and investing it in equal pieces over months instead of all at once. Its appeal is real: if the market falls right after you invest, the later pieces buy cheaper. Its cost is also real. Over most periods the market’s expected return is higher than cash’s, so money that waits on the sidelines usually earns less than money that is invested. Vanguard’s studies of rolling historical periods found that investing a lump sum immediately beat a twelve-month schedule about two-thirds of the time; the simulation in this lesson, with a stated model rather than history, gives the lump sum the lead in about three paths in five. So dollar-cost averaging is not a way to earn more. It is **regret insurance** paid for with expected return: it narrows the range of outcomes, especially the painful one where everything was invested just before a fall, and in exchange it gives up some growth most of the time. That can be a good trade for an investor who would otherwise not invest at all, or who would abandon the plan after a bad first month. If you use it, make it short and automatic — three to twelve months, scheduled in advance — because a schedule that waits for a better moment has turned into market timing. One confusion is worth clearing up. Investing part of every paycheck is often called dollar-cost averaging, but it is not the same decision. There is no lump sum being held back: the money is being invested as soon as it exists, which is exactly what the lump-sum evidence recommends. Automatic contributions from income are simply good practice; the only real dollar-cost-averaging choice is what to do with money you already have. • Lump sum usually wins, because the market’s expected return beats cash — about two-thirds of the time historically. • Dollar-cost averaging is regret insurance bought with expected return. • If you use it: short, scheduled, automatic. • Investing each paycheck is not dollar-cost averaging — it is investing money as soon as it arrives. $120,000 to invest: the simulation’s answer (12-month schedule) — Lump sum ahead after a year: About 3 paths in 5 · Median lead of the lump sum: About 2% of the money · Worst 5% of outcomes for the lump sum: About 12% behind — the regret the schedule insures ←

Rebalancing that runs itself: target-date funds and retirement withdrawals

For many households the most reliable rebalancing rule is the one they never have to execute. A **target-date fund** holds a stock-and-bond mix chosen for a retirement year, rebalances it continuously inside the fund, and shifts it gradually toward bonds as the date approaches — the glide path. Index-based versions charge little, and because the rebalancing happens inside one fund there are no trades to remember and, in a retirement account, no tax. The trade-off is control: the glide path is the fund company’s, not yours, and two funds with the same target year can hold quite different amounts of stock. In retirement the job changes shape, because money is flowing out rather than in. The cheap way to rebalance is then to **spend from whatever is overweight**: after a strong year for stocks, take the year’s withdrawal from stocks; after a bad one, take it from bonds or the cash sleeve and let the stocks recover. That turns every withdrawal into a small rebalancing trade, often removes the need for any other selling, and puts the sequence-of-returns protection of PF12 into the same routine. Either way the principle is the one this lesson started with: the portfolio should carry the risk you chose, and the machinery should keep it there without anyone deciding, in the middle of a market move, whether this is the moment to act. • Target-date funds rebalance inside the fund and glide toward bonds automatically. • Check the glide path: same target year, different stock weights. • In retirement, withdraw from whatever is overweight — rebalancing by spending. • The best rule is the one that runs without a decision in a market move. Rebalancing by withdrawal, one retiree, two years — Stocks had a strong year and are over target: Take the year’s spending from stocks · Stocks fell and are under target: Take it from bonds or the cash sleeve ← · Weights back inside the band: Withdraw pro rata — nothing else to do

Sources

• Rebalancing frequency and thresholdsVanguard, “Best Practices for Portfolio Rebalancing”
• Investing a lump sum at once versus over timeVanguard, “Cost averaging: Invest now or temporarily hold your cash?”
• Diversification return from rebalancingBooth & Fama, “Diversification Returns and Asset Contributions” (Financial Analysts Journal, 1992)