Our proven methodology:
It’s science, not speculation.

Modern Portfolio Theory

The Rebalance IRA strategy follows a widely accepted approach known as modern portfolio theory (MPT). Developed through time-tested finance research, modern portfolio theory seeks to increase investment return while lowering risk. The heart and soul of the concept is diversification. The idea is to own a variety of asset classes, thus avoiding the concentration of risk into any given single investment.

It starts with you. The first step is to identify your personal, acceptable level of risk tolerance. Then we build a diversified portfolio that offers the maximum return for your chosen risk level.

Diversification is more than simply putting your eggs into different baskets. It actively lowers risk. That’s because asset classes generally are “uncorrelated,” that is, as one declines in value, another rises. For instance, you likely have noticed that when stocks fall in price, bonds rise, and vice versa. The stabilizing effect of diversification is amplified by adding up to six asset classes to your portfolio. A thoughtful collection of asset classes thus offers a lower investment risk than any single asset. Interestingly, research shows that adding asset classes that some might perceive as “risky” in fact lowers the overall risk in a portfolio. For this reason, diversification rightly has been described as “the only free lunch in the investment game.”

MPT is the opposite of “stock picking.” Analysts who pick stocks attempt to find a small group of stocks or bonds that they believe will outperform entire markets represented by a corresponding index, such as the S&P 500. Instead of analyzing and purchasing single companies or sectors, however, MPT counsels you to buy the index itself.

The theory assumes that investors are rational and that markets are efficient. Over time, owning an index is likely to lead to a higher return compared to owning a subset of individual stocks chosen by an analyst. Research has shown this to be true: You can get a solid, wealth-building return while taking far less risk.

An important concept to understand is volatility, a measurement of how far below average an investment’s “bad years” are likely to be. Short-term volatility can be thought of as “risk.” How much might a single asset decline in value? How would you, as an investor, react to such a short-term decline?

Using modern portfolio theory, investments are statistically measured in terms of both their expected long-term rate of return and their short-term volatility. A portfolio is then created that combines assets in such a way that the return is the weighted average of the assets held within.

By combining assets whose returns are uncorrelated, MPT seeks to reduce the total variance of the portfolio. A reliable return with lower risk and lower cost, compounding over time, creates a winning retirement portfolio.

In a given year, different asset classes perform differently, making it difficult to predict which asset will perform best. It might be entertaining to try to predict the “best” asset class, but such forecasting is risky and unsustainable. Research demonstrates that people who jump from asset to asset—leaping from rock to rock, faster and faster across a rushing stream—usually finish with worse results than an investor who undertakes a careful, disciplined process. People simply can’t predict the future, and when they try they often end up knee-deep in trouble.

Finance research experts, major endowments, pension funds, and private investment professionals broadly agree that MPT is a safe, solid, repeatable method for managing a portfolio. Historically, however, MPT-based advice has been available only through high-end financial advisors who typically require minimum account sizes of $1 million and who charge annual fees of at least 1% of assets under management.

Rebalance IRA seeks to “democratize” modern portfolio theory by bringing this level of advice to everyone for a fraction of the cost.

Portfolio Recommendations

Financial planning largely consists of determining an asset allocation that is appropriate to a specific investor. To achieve this, Rebalance IRA seeks an individualized asset allocation using multiple asset classes, including U.S. stocks, bonds, real estate, foreign equities, and emerging market stocks. The primary factors to be considered are an investor’s age, the timeframe in which he or she needs to use funds, past investment experience, and the ability to stick to an allocation in volatile markets.

Rebalance IRA portfolios are constructed by carefully weighting each factor. We ask several subjective questions in order to learn the level of risk an individual is willing to undertake and the consistency in his or her answers. In addition, clients are asked objective questions. The target, using as few questions as possible, is to learn whether the investor is likely to have enough money saved at retirement to meet his or her real spending needs. The greater the “excess” income, the more risk the client is able to take. Our approach also considers behavioral finance research, which shows that individuals have a propensity to overstate their true risk tolerance.

After the interview, Rebalance IRA calculates a specific “score,” which is then used to select a portfolio that has appropriate levels of bond and equity exposure for that investor.


Index Funds

Historically, financial advisors and brokerage firms have used mutual funds to gain exposure to particular asset classes. Mutual funds are convenient. They are easy to choose from and use a well-understood rating system offered by Morningstar. However, many advisors receive an annual commission from mutual fund companies, called a “12b-1” fee. And most mutual funds are actively managed, meaning fund managers attempt to pick individual securities that they believe will outperform a benchmark, usually an index.

Over the years, a significant amount of research has shown that between 80% and 90% of actively-managed mutual funds underperform the market—despite the fact that fund managers are being paid to do just the opposite. In 2010, Morningstar admitted that its rating system does not successfully identify mutual funds that will outperform the market in the future.

As a result, the passive “index” fund was developed. An index fund holds stocks in all of the companies within an overall market, as defined by that index. Some of the most popular indexes are the S&P 500 (which tracks large U.S. public companies), the Russell 2000 (small U.S. public companies), and the MSCI EAFE (tracking the largest companies in developed foreign countries). When one invests in an index fund, rather than trying to select a few securities that will “beat” the index, the investor receives nearly the exact return of the total market as represented by that index.



Exchange-traded funds (ETFs) are the least expensive and most tax-efficient type of index fund.

ETFs allow you to invest in practically any market at very low cost. They trade on the stock exchange and can be purchased through any discount broker—just like a stock—at a cost averaging between $4 and $10 per trade (and commission-free at some brokers). ETF management fees for Rebalance IRA average less than 0.2% per year.

More than 1,200 ETFs have been created. As a group, these funds now hold $1 trillion in assets. Understandably, the wide variety of ETFs has led to investor confusion about which funds are most suitable for building an asset allocation.

Not all ETFs are created equal, it’s true. Fund selection is based upon several criteria:

1. Exposure to Core Asset Classes.

Since our methodology is based upon modern portfolio theory, we seek exposure to broad asset classes that have three common characteristics:

  • they provide a valuable counterbalancing effect within an investment portfolio. For example, real estate offsets inflation, but bonds protect against a financial crisis,
  • they rely fundamentally on market-generated returns, not on active management of portfolios. In most asset classes, active managers cannot outperform the market. Because meeting our investment objectives is critical, a core asset class cannot be based on “lucky picks” and
  • they are selected from broad, deep, liquid markets, for safety and flexibility.

As a core building block of a portfolio, we focus on well-established marketplaces, not sector funds (such as technology) or indexes based upon a fashionable, “flavor-of-the-month” thinking, such as a quant method of reweighting stocks.

2. Asset Size

Rebalance IRA only uses the largest ETFs, averaging $6 billion in net assets with volumes of more than 1 million shares per day. This affords sufficient liquidity and provides narrow bid/ask spreads, reducing both cost and risk.

3. Fees

The typical weighted portfolio of ETFs we use features an average fee of less than 0.2%. Low fees are the key to achieving higher returns.

4. Sponsors

Rebalance IRA uses ETFs sold by proven, well-known providers, such as Vanguard, iShares, and State Street Bank and Trust. These three firms account for nearly 90% of all ETF assets and are the most highly regarded in the industry. Vanguard is a not-for-profit institution and has the lowest fees, so it tends to keep the other ETF providers “honest.” In addition, the skill sets and technology for managing and constructing ETFs are highest among these three firms.

5. Index Construction

ETFs are evaluated based upon index construction. We seek funds that precisely replicate a given index’s performance over long periods. There are as well various ways to index a market. For example, small cap U.S. stocks are generally indexed using the Russell 2000 Index. But the S&P SmallCap 600 Index is a superior alternative, due to its construction and how it avoids the drag from what is known as the annual “Russell 2000 trade.”


Rebalancing is essential to modern portfolio theory. The theory requires specifically defined target allocations based upon the investor’s objectives, expressed as percentages. The sizes of the corresponding slices of the portfolio “pie” must be rigorously maintained through the ups and downs of the market. The discipline of rebalancing is essentially a buy-low, sell-high strategy, but one that is both counterintuitive and contrarian.

In practice, as an asset class outgrows its slice of the pie, gains are trimmed and added to underperforming asset classes, bringing the portfolio back into line with the original targets. This can be emotionally difficult to do. Yet research and backtesting demonstrate that this simple discipline adds to performance year-over-year and, more importantly, manages risk. Rebalanced portfolios earn 0.4% more per year on average compared to portfolios that are not rebalanced, and do so with less risk.

For instance, an analysis performed by Professor Burton Malkiel of Princeton University, found that, over 10 years, rebalanced portfolios can earn 1.47% more per year on average compared to portfolios that are not rebalanced, and do so with less risk.*

When it comes to rebalancing, our software is designed around a proprietary algorithm that guides portfolios back to target allocations as specific conditions are met. When an asset class is out of balance, an alert is generated for our traders and the entire portfolio is soon rebalanced.

Rebalance IRAs are rebalanced on average twice a year. Client account withdrawals and contributions also can trigger rebalancing.

*Source: Professor Burton Malkiel, Princeton University. 60% Russell 3000 / 40% Lehman Aggregate Bond indexes rebalanced annually 1996 – 2010.

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