What Is Rebalancing and How Does It Help Saving for Your Pension in Germany?
The most important task in investing is strategic asset allocation - this fundamental choice and composition determine 95 % of your returns before taxes and costs. Once you have made this decision for your portfolio composition, you should stick with it for the long term. Only when there are fundamental changes, such as when you decide to retire, when interest rates change dramatically, or when the global political situation changes dramatically, should you reassess your entire portfolio.
However, this still leaves you with one big problem: the weights in the portfolio will change all the time because of the fluctuations in the market.
Let’s assume you invest 100.000 € in 2 stocks ETFs with weights of 50 % each. After a while, your portfolio did grow and became 105.000 €. This was the result of the first ETF increasing to 54.000 € and the second one to 51.000 €. The portfolio weights became 51,43 % and 48,57 % respectively.
You may ask, "My portfolio is growing, so what is the problem?"
What is rebalancing and why is it necessary?
The weight change means that the portfolio is now deviating from the target portfolio that was carefully set in line with your investment objectives. To bring the portfolio back to the original, you need to sell a portion of ETF #1 (1.500 €) and buy ETF #2 by the same amount, so the two ETFs will end up with the same amount invested of 52.500 € or 50 % each. When you do so, you are rebalancing: Rebalancing is the process of buying and selling portions of your portfolio in order to set the weight of each asset class back to its original, targeted state.
All professional asset managers conduct such rebalancing. If not then over time your portfolio may become really lopsided and have more risk or one-sided exposure than is desired.
The graph below shows a simple example of an equally weighted allocation with two ETFs and how turbulent a portfolio can be if it is not rebalanced regularly and the weights are not put back to 50% each.
Please note that this example and its numbers is for illustrative purposes only.
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When should I rebalance my portfolio?
There are several types of rebalancing strategies: the most common is called "calendar rebalancing”. As the name suggests, you systematically rebalance your portfolio on a monthly, quarterly, or even semi-annual basis. However, research shows that this strategy is suboptimal because you sometimes rebalance the portfolio when it is not necessary, and because the timing is standardized, it is not (always) ideal. This increases transaction costs and reduces the overall performance of your investment.
A more efficient strategy supported in the finance literature is to rebalance when there is a significant deviation from the desired allocation. This should be executed in a smart way that does not allow for a large deviation and high risk.
Based on this logic, Pensionfriend has built, after ample testing, its own algorithm that efficiently rebalances the portfolio only when needed and can generate an additional gain of 0,1% to 0,2 % per year on average, based on a back test of over 25 years. It also guides the regular decision of where to put additional money. For example, our algorithm yields 0,19% before cost for our Global Outperformance portfolio, while a quarterly rebalancing, would yield 0,05% per annum, with a slightly higher cost.
For those who are making regular – say monthly – contributions to their portfolios, the rebalancing is slightly different. The optimal way is to allocate the money first to the ETF that has a lower weight relative to its target. If the target is met, you split the residual accordingly based on your initially desired weights. If the “fresh” money is not sufficient for ETF #2 to meet again its desired weight then parts of ETF #1 have to be sold in order to buy the remaining portion of ETF #2.
How does rebalancing within a tax wrapper work?
When rebalancing an investment portfolio, it is important to be aware of the taxes you will incur when selling profitable investments. Without a tax wrapper rebalancing incurs costs. If you invest in Germany, a capital gains tax of 25 % plus a solidarity surcharge of 5,5 % of the tax will be levied on gains in excess of the tax-free savings allowance of 1.000 € per year. In total, you will have to pay 26,375 % tax.
You can avoid these costs by investing in ETFs through a private pension plan rather than directly. This way, rebalancing also takes place within the pension plan, which acts as a tax wrapper and ensures that rebalancing does not create a taxable event. This allows you to keep your portfolio on track and enjoy tax-free compounding. You can use our investment calculator to discover the benefits of investing in a private pension plan and how much you can save compared to investing directly in ETFs.
