Allocation Methodology: Buy Low Sell High: Opportunistic Rebalance & Tolerance Bands

Even professional money-managers find it difficult to tell whether a stock is high and going down or low and going up. How is the average dude supposed to proceed if he wants something more than index funds or target funds? The method described here takes the guesswork out of it and still makes better than average gains. It can be applied to either mutual funds or individual stocks and bonds. And because it provides mathematical formulas, it works best in a volatile market—when most people become nervous and don’t know what to do.

The basic principle of buy low sell high can become disciplined if you designate a specific percentage to each allocation of your portfolio, and then rebalance to it periodically. But doing so annually or quarterly on a specific date as has traditionally been advised may not coincide with the widest market swings. Ideally, you want to rebalance when any specific allocation gets far enough out of line that it is worth selling the high allocation and buying the low allocation.

Gobind Daryanani, CFP, Ph.D. wondered what percentage would make it most worthwhile for his clients. Instead of rebalancing by calendar prompts, Daryanani proposed percentage prompts in a method that has come to be known as opportunistic rebalancing. The key is to look often and rebalance less.

Daryanani conducted a research study in which he determined the optimum deviation allowable from the desired allocation, and the optimum frequency of checking. He concluded, “Look often; rebalance less.” Every two weeks is a good interval to check the current valuations and calculate allocation percentages. More than that is just too often; longer than that misses some short-term volatile opportunities.

This requires several investments, at least one holding that’s fairly stable and several that are volatile, but likely to move independently of each other. When one holding is doing very well, you can sell some of it to invest further in one that is relatively cheap. That cheap holding, if volatile enough, will eventually be high enough to sell the gain in order to buy something else that’s cheap, and so on.

Daryanani showed not only that it is best to allow an allocation to stray from its target by approximately 20% before rebalancing, but that it is not necessary to rebalance everything to its exact target allocation. Among other things, that usually incurs unnecessary trading expenses.

Rebalancing to within ±10% of the target allocation—called the “tolerance band”—proved to be sufficient in the computer simulations he tested. This conservative rebalance permits one to rebalance one or two other allocations that are not quite as far out of balance, without touching those closer to their targets. It also allows for a limited amount of speculation about the direction in which the various market sectors may be headed.

The algorithm described here has been employed in the top-tier software, iRebal, developed by Daryanani. The set-up charge of $10,000 and annual fee of $20,000 gives some indication of its value and sophistication. The basic principles, however, have been described in professional journals and can be applied by anyone who can make a spreadsheet.