How should contributions/withdrawals be treated for rebalancing?

[Sam Brazil]

Let's say you start with 10k/10k/10k/10k...now let's say the prices of the assets change to 10k/11k/8k/7k...none has hit the 15%/35% rebalance bands. So at this point do nothing.

But then what if at that point I add 10k cash? Should the 10k be spread evenly? Or go disproportionately to the lowest performing asset classes?

Or what if I've got 10k/11k/8k/7k, and now I've got to withdraw 5k...do I take it out from each asset class evenly? Or withdraw disproportionately from the highest performing asset classes?

[Pet Hog]

I'll assume that 10k/11k/8k/7k refers to cash, stocks, bonds, and gold, respectively (total: $36k; 28/31/22/19%).  For any contribution, I can think of six strategies:

(1) Add all to cash.
Pros: simplicity, no fees (maybe one buy of short-term bonds or ETF), no taxes.
Cons: distorting portfolio percentages, possibly triggering a rebalance in the wrong market climate.
In your example, giving a 20k/11k/8k/7k portfolio ($46k; 43/24/17/15%).  Rebalance triggered, to 11.5k/11.5k/11.5k/11.5k.

(2) Buy the single lowest-value asset class.
Pros: simplicity, buying low, decreasing volatility (if contribution is small), no taxes, one trading fee.
Cons: distorting portfolio percentages, increasing volatility (if contribution is large), possibly triggering a rebalance in the wrong market climate.
In your example, resulting in a 10k/11k/8k/17k portfolio ($46k; 22/24/17/37%).  Rebalance necessary, to 11.5k each.

(3) Buy more than one low-value asset class to (partially) rebalance.
Pros: buying low, decreasing volatility, no taxes.
Cons: fees (up to four buys), losing momentum.
In your case, add to each asset class so that they're fully rebalanced at 11.5k each.

(4) Add to all asset classes equally (partial rebalance).
Pros: no market timing, decreasing volatility, delaying next rebalance, no taxes.
Cons: fees (four buys), losing some momentum, possibly missing the next rebalance signal.
In your case, add $2.5 k to each class, giving 12.5k/13.5k/10.5k/9.5k ($46k; 27/29/23/21%).

(5) Add to all asset classes in proportion to their current percentages.
Pros: maintaining portfolio percentages, allowing market to dictate when rebalancing occurs, maintaining momentum, no taxes.
Cons: buying high, fees (four buys), maintaining higher volatility.
In your case, divvy up the 10k into blocks of 28/31/22/19% ($2.8k/3.1k/2.2k/1.9k), then add to the four asset classes, giving a portfolio of $12.8k/14.1k/10.2k/8.9k ($46k, 28/31/22/19%).

(6) Rebalance with each cash contribution.
Pros: buying low/selling high, decreasing volatility
Cons: fees, taxes, trading too often, losing momentum

Personally, I don't like the idea of a cash contribution initiating a rebalance.  I think that should be independent of my input, dictated solely by the market.  So I prefer strategies (3), (4), and (5), with the latter being my favorite.  But you'd have to take into consideration trading fees and taxes.

For withdrawals, you could do the inverse of each of these six strategies, but taxes will come into play almost every time, so taking the money solely from cash might be the best move.  In your case, however, a withdrawal of $5k would result in a portfolio of $5k/11k/8k/7k ($31k; 16/35/26/23%), which would trigger a rebalance from stocks into cash, which might not be too costly taxwise. 

[Kshartle]

Where did the 10k come from

That's a big injection all at once when the portfolio is only 40k to begin with. It's more like you already were overweight in cash.

Just add to the lagging assets. If there's virtue in having the 4x25 split then why deviate from in unless the market forces it?

Within a short amount of time, adding savings to the PP should be a very small affair and not alter the composition very much, especially if you don't wait a long time.

So do #3. In this instance you would do 4 buys but the next time probably only three or two and once you start adding monthly it will probably just be one lagging asset purchase every month.

[mattymcmatt]

How often will you be adding a large percentage of cash to the PP?

I recently went through this process as I sold all of my stocks and moved into the PP.  For various reasons, there are some investments that took longer to sell so basically I just set out with the goal that I wanted to have a roughly equal allocation by the time I was finished selling all my other investments.

If this 10k is a one time injection and you don't foresee other large injections, I would use it to make sure your allocations are roughly equal to 25%.  If it will be an ongoing thing, you could go with the strategy of bumping up the lower ones and making sure each allocation stays in the 15-35% band.

For withdrawals, I believe the way to go is to take it from the cash part.  If it reduces the cash to under 15%, then do a rebalance.

[blackomen]

I buy up to 2 assets each time with the cash contribution with my monthly contribution.

For larger one-time contributions, it's fine to buy all 4 assets, and I usually default to rebalancing to 25/25/25/25 using cash, unless I have views on some of the assets..  in that case, I'll choose a weight in the 20-30% range for each.

[mortalpawn]

I asked this question months ago and someone weighed in and said they had modeled these scenarios out using backtesting.

The best strategy for new additions to maximize long term returns was to add them evenly (25/25/25/25) - and not use new money to rebalance the portfolio until the bands were hit naturally.  So now I add mine evenly each month.

[rocketdog]

Personally, I'd always aim to keep things as balanced as possible.  So $10K in new cash would get invested in such a way as to even out my investments (assuming there are no transaction costs).  Same for withdrawals, where I'd skim more from the best performing assets than from the worst performers, bringing everything into balance again.  That's the essence of "buy low, sell high", isn't it?  Or maybe that's just me.