Rebalancing and Correlations - Buy Low, Sell High

DISCLAIMER: Educational content, not investment, tax or legal advice. Consult licensed advisor.

Intro: Why Portfolios Die Without Rebalancing?

Assume 2019 you start with Golden Butterfly: 20% each of 5 blocks, 100k PLN (~$25k). S&P rises 90% to 2024, gold 40%, long bonds -25%. Without rebalancing in 2024 you have:

• Stocks: 38% instead of 20%
• Gold: 28%
• Long bonds: 15%
• Short bonds: 10%
• SCV: 30%

Your “safe” portfolio became aggressive stock portfolio without your knowledge. In crash you lose 35% instead of 12%. That’s not Golden Butterfly anymore. It’s random concentrated bet.

Rebalancing is restoring portfolio to target. It’s only mechanical system that FORCES you to sell high and buy low, without emotions.

Table of Contents

1. What is rebalancing and why it’s premium
2. 3 Methods: Calendar, Threshold, Hybrid
3. Threshold formula
4. Correlations - why everything rises together until suddenly not
5. Correlation matrix of main asset classes
6. Why important for trader
7. How to apply in practice - 15 minute quarterly algorithm
8. Case Study: Rebalancing 2020-2023 in PLN / USD
9. Beginner mistakes
10. Exercises and Checklist

1. What Is Rebalancing and Why Gives Extra Return?

Definition: Selling assets that grew above target and buying those that fell below target, to return to initial allocation.

Rebalancing premium: Vanguard research (2023) shows regular rebalancing adds 0.2-0.4% annually vs buy-and-hold without rebalancing, and LOWERS volatility by 1-2%. Why?

Because forces contrarian behavior. When everyone buys tops, you sell.

`Target_Weight = Initial_Allocation

Deviation = Current_Weight - Target_Weight

Deviation% = (Deviation/Target_Weight * 100%

2. Three Rebalancing Methods

A) Calendar (Time-based)

Rebalance every fixed period: month, quarter, year.

• Pros: Simple, easy to automate, low transaction cost.
• Cons: May rebalance without need (costs) or too rarely (drift).
• Recommendation: Quarterly for portfolios < $60k / 250k PLN, monthly for >$125k.

For Pole: Mar 15, Jun 15, Sep 15, Dec 15 - after quarterly dividend from ETF, before holidays.

B) Threshold-based

Rebalance only when deviation exceeds threshold.

Threshold formula:

Rebalance_Threshold = |Current - Target| > 20\% * Target

Or absolute version popular at Bogleheads:

Trigger = |Current - Target| > 5% ( percentage points

Example: Target 20% gold. 20% * Weight_target = 0.20 * 20% = 4%. So rebalance when gold has <16% or >24% of portfolio.

5pp version simpler: rebalance when gold has <15% or >25%.

Pros: Rebalance only when needed, lower costs, better performance in trends. Cons: Requires monitoring, may miss in vacation.

C) Hybrid (My Favorite for Trader)

Check quarterly, but rebalance only if exceeded 20% relative threshold.

Algorithm:

1. Quarterly login
2. Calculate weights
3. If any block deviated >20% relative (or >5pp absolute) -> REBALANCE whole to target
4. If not -> do nothing, drink coffee

Data: Hybrid gives best Sharpe and lowest transaction cost per Daryanani (2008).

3. Correlations - Why “Diversification” Fails When You Need It Most?

Correlation measures how two assets move together: -1 (perfect opposite) to +1 (perfect together). 0 = no relation.

Corr(X,Y) = (Cov(X,Y)/σ_X * σ_Y

Myth: “Just buy stocks and bonds, they are negatively correlated”. They were 2000-2020. In 2022 correlation jumped to +0.6 and both fell.

Correlation Matrix 2010-2024 (monthly returns USD)

Lesson: Only asset truly uncorrelated with stocks long term is cash and partially gold. BTC correlated 0.35 with NASDAQ - NOT hedge, it’s leveraged beta.

Correlations rise to 1 in panic. March 2020 everything fell together for 2 weeks, then diverged: gold and long bonds bounced first.

4. Why Important for Trader?

Because rebalancing is mental training opposite to FOMO.

As trader you trained to cut losses and let profits run (trend following). In long-term portfolio you do opposite: trim profits and add to losers (mean reversion). Hurts but works.

Second: correlations affect total risk. If you have 60% portfolio in S&P and day-trade S&P, real exposure to “US stock” factor is not 60% retirement but 60% + 100%*trading leverage = 200%+. In crash double hit.

Therefore as trader you must have in retirement assets with low correlation with your style. If you trade stocks, add gold and long bonds. If you trade commodities, add more stocks.

5. How to Apply - 15 Min Quarterly Algorithm

Google Sheets Columns: A: Asset | B: Ticker | C: Target % | D: Current Value PLN | E: Current Weight | F: Deviation vs Target | G: >20%? | H: Action

Step by step Mar 15:

1. Login broker, copy values each ETF to column D.
2. Calculate SUM total.
3. Column E = D / SUM
4. Column F = E - C
5. Column G = ABS(F) > (C*0.20) ? “REBALANCE” : “OK”
6. If any “REBALANCE” -> calculate desired values: SUM * Target%
7. Place orders: sell excess (first what’s on profit to avoid tax if possible), buy deficit.
8. Save date and transaction costs.

Costs: XTB 0% commission on ETF up to 100k EUR/month, so cost only spread 0.05-0.15% + tax on sale (19% profit). So don’t rebalance weekly.

Tax trick PL: In IKE you pay no Belka tax from rebalancing! So 100% rebalancing do in IKE, and on taxable account only add with new capital (rebalancing via cash flow).

Cashflow_Rebalancing: Buy only what's below target with new deposits, not selling`

Best method for portfolios where you contribute regularly. Zero tax.

6. Case Study: Rebalancing 2020-2023 in PLN / USD

Marek has 100k in Golden Butterfly, 20% each = 20k PLN / $5k.

March 2020: COVID Crash

• Large stocks: 20k -> 13k (-35%)
• SCV: 20k -> 11k (-45%)
• Long Bonds: 20k -> 25k (+25% flight to safety)
• Short Bonds: 20k -> 20.5k
• Gold: 20k -> 23k (+15%) Total: 92.5k PLN. Weights: Stocks 14%, SCV 11.8%, Long 27%, Short 22.1%, Gold 24.8% Deviations: Stocks -30%, SCV -41% -> TRIGGER. Rebalance: sell 5k long bonds and 3k gold, buy 7k stocks and 9k SCV at bottom!

December 2021: Bull After 2020 rebalance portfolio grew to 135k. Stocks now 32% vs 20% target. Sell stocks at top, buy cheap bonds.

Result: Portfolio with quarterly rebalancing 2020-2023: 132k PLN ($33k) (8.1% CAGR). Without rebalancing: 126k (6.8% CAGR) and 22% higher vol. Difference 6k PLN for 15 min * 16 quarters = 240 min work. 25 PLN per minute.

7. Beginner Mistakes

1. Too frequent rebalancing: Weekly rebalancing eats 0.8-1.5% yearly on spreads and taxes. Vanguard research: yearly or 20% threshold is optimal for retail.
2. Rebalancing in panic: “Stocks falling, won’t buy more”. That’s exactly when rebalancing works. If you can’t, set orders ahead.
3. Ignoring dynamic correlations: Assuming past correlation = future. Stock-bond correlation flips sign every decade. Build portfolio on low long-term correlations, not negative.
4. Rebalancing on taxable account via selling: Always first use cash flow. Only when drift large, sell and pay tax.

8. Practical Exercises

Exercise 1: Create sheet with 5 assets, enter targets 20% each, simulate stock drop -30% and gold rise +20%. Calculate weights and check rebalance trigger. Exercise 2: Download VWCE and AGGH data last 3 years (stooq.pl). Calculate 60-day rolling correlation. See how jumped in 2022. Exercise 3: Calculate rebalancing cost: you have 50k portfolio, must sell 5k ETF with 1k PLN profit. Tax 19% = 190 PLN + spread 0.1% = 5 PLN. Was it worth waiting for cash flow?

9. Checklist

• Chose method: hybrid quarterly + 20% relative / 5pp absolute threshold
• Set calendar reminders: Mar 15, Jun 15, Sep 15, Dec 15
• Created Google Sheets with target / current / deviation columns
• Decided: cash flow rebalancing as first option in taxable portfolio
• In IKE rebalance without limits (no tax)
• Know correlations of my blocks and which truly diversify my trading exposure
• Tested historical difference rebalanced vs not (PortfolioVisualizer)

Summary and Next Steps

Rebalancing is not “extra work”. It’s system that mechanically implements saying “buy when blood on streets”. Works because painful.

Formula |Current - Target| > 20\% * Target gives you objective trigger.

Next lesson we go into most important cost topic for Pole: Accumulating vs Distributing ETFs, UCITS, TER, tracking difference and domicile. Learn why choosing IE vs LU is 0.6% more per year.