Four Reasons to Rebalance

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Although the rebalancing bonus is easy to understand, its effectiveness is difficult to measure. Over any given historical period, there exists one holding which performed the best. If you had invested 100% into this all-star holding, you would have had the best return. In the same way at any level of complexity — funds, sectors, asset classes, asset allocations, and entire portfolios — there exists one winner for any given time period.

The tricky bit is that, although there is an obvious historical winner, there is no obvious future winner. Which holding, fund, sector, asset class, or asset allocation will have the best return for the next 30 years? There is no one who can predict the right answer.

If you are using historical data to test the rebalancing bonus, you run into the problem that when you are trying to test the effects of rebalancing you really end up testing your asset allocation. However, there are at least four reasons to rebalance where the benefit can be demonstrated or measured.

Stay on the Efficient Frontier.

For any given portfolio you can measure its level of expected risk and its level of expected return. Expected return is typically measured by its long-term average return while expected risk is typically measured by its long-term standard deviation.

If you blend funds together to create a large set of different portfolios, you can calculate each portfolio’s expected return and expected risk and then graph that data onto an efficient frontier graph.

With expected return on the Y-axis, the higher a point is on the graph the more expected return it has. With the expected risk on the X-axis, the farther to the right a point is the more volatility you’d expect that portfolio to have.

To be on the efficient frontier, a portfolio needs to have the highest expected return for its expected risk.

After all, if you could achieve the same expected return without as much volatility, that would obviously be superior since withdrawing from an overly volatile portfolio risks running out of money.

We tend to use efficient frontier analysis to determine our allocation to various sectors in an asset class. For example you can see an efficient frontier analysis with Chile and the S&P 500 in the article “Why Invest In Chile?

The efficient frontier comes into play when evaluating rebalancing because a buy-and-hold strategy will see its portfolio drift around the graph. It may start on the efficient frontier but as certain sectors perform better than others, those winners will start to be a larger portion of the portfolio drifting the portfolio overall to a new expected risk and return. That new risk-return plot may or may not be on the efficient frontier.

If the buy-and-hold portfolio drifted towards a riskier but higher expected return blend, then it may appear to beat rebalancing which would have bought and sold to keep the portfolio where you started it. However the buy-and-hold victory is only because the investor accidentally ended up being riskier than they intended. If they had simply picked a more aggressive asset allocation from the start, they could have stayed on the efficient frontier the entire time and commanded a higher expected return than that of the accidental drifted portfolio.

Asset allocation, from its start, is designing a portfolio which has the appropriate level of risk and return to meet your financial goals. If you are willing to let the portfolio drift more aggressive or more conservative, then it would have been better to change your asset allocation intentionally to an efficient version of that level of risk. Simply letting your portfolio drift according to whichever way the market winds are blowing is likely to give you an inefficient portfolio. If you are willing to take more risk, you likely can earn more by taking that risk from the start.

Keep enough Stability to meet withdrawals.

Portfolio construction begins with the most basic allocation between investments that offer a greater chance of appreciation (stocks) and those that provide portfolio stability (bonds). Decisions made at this level are the most critical in determining how well behaved your portfolio returns will be. There is an optimum allocation between stocks and bonds for a given withdrawal rate, and we customize this allocation for each client based on their cash flow needs.

Rebalancing from stocks into bonds reduces your returns on average since bonds have a lower average return. In this way, portfolio rebalancing between stocks and bonds is more likely to perform worse than simply buying and holding in most model portfolios. After all, if left in a buy-and-hold strategy, appreciation will grow faster, outpacing bonds to become a larger percentage of the portfolio and then help pull up portfolio returns through compounding.

However, we add bonds to a portfolio for a reason. Having everything in stocks risks having to take money out after poor market returns early in the sequence and therefore not having enough money remaining to grow when the markets recover.

By adding the Stability of bonds, you are able to smooth returns, lowering expected risk and return but increasing the chance of meeting all of your withdrawal needs.

Even though withdrawals and market movements move your portfolio out of balance, by rebalancing regularly, you are able to maintain the correct amount of smoothing presence of Stability in your portfolio to achieve your financial goals.

Maintain diversification by breaking up concentration.

The most volatile and risky sectors normally have the highest expected return. In a buy-and-hold strategy, those volatile sectors will grow to become larger and larger portions of the portfolio. This will increase the portfolio’s standard deviation and make choppier returns for the portfolio in the future. If one sector, such as Technology does particularly well for a while, you might see your Large Cap, Technology, and certain Foreign investments or sectors become bloated with Technology’s gains.

Without any rebalancing, your portfolio could over time become concentrated in one industry.

By rebalancing, you are able to trim back industries that have performed well and balance the portfolio so it is diversified across the industries. This maintains a healthy diversification to protect you from losing too much to an unexpected bubble or crash in one industry.

Increase expected return on contrarian market movements.

Investments consistently outperform investors. When we look backward can we see that mutual fund investors underperform the very mutual funds they are invested in because they chase returns moving out of funds after they have gone down and moving into funds after they have gone up. It is the advisor who recommends sticking to a long-term plan who, in the end, will provide the most value.

Rebalancing is a contrarian movement and the opposite of chasing returns. The asset classes which have performed well are the ones above your targets. Those that have performed poorly are the ones below their targets. Rebalancing means you are selling some of the darlings of your investments to buy more of the outcasts.

Rebalancing is the most helpful when it is most difficult. We are biased to believe that recent occurrences will continue. When it comes to the markets, this instinct must be overcome. Rebalancing involves selling the investments that have appreciated and buying the assets that have recently gone down.

Rebalancing your portfolio provides a rebalancing bonus. The exact amount is proportional to the lack of correlation between the asset classes and the volatility of the markets. Rebalancing can both reduce risk and boost returns.

Studies have suggested that even an investment advisor who only helps you set an appropriate target asset allocation and rebalance once a year might earn 1.6% more for your portfolio than a buy-and-hold strategy.

In these ways, rebalancing can be of great value to a long-term investor’s portfolio.

Photo by Raul Angel on Unsplash

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Chief Operating Officer, CFP®, APMA®

Megan Russell has worked with Marotta Wealth Management most of her life. She loves to find ways to make the complexities of financial planning accessible to everyone. She is the author of over 800 financial articles and is known for her expertise on tax planning.