Is Rebalancing a “Myth”?

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Stacked stones

Last year I was given an article which reached this conclusion:

So is rebalancing necessary? Even though the media and Vanguard may have you think so, when you look at the evidence – even after a topsy-turvy stretch as 2008-2010 – there is little benefit when you think about risk.

It is unusual to see an article challenging the benefits gained from rebalancing. Here are a few of the articles on how regular rebalancing boosts returns and maximizes the long-term success of your retirement planning:

This particular article was published in the a special expanded 16-page issue of “The Independent Adviser for Vanguard Investors” newsletter, a paid subscription ($129/year) publication of Fund Family Shareholder Association which is edited by Daniel P. Wiener.

Wiener’s analysis consisted of looking “at the impact of time-dependent rebalancing on a 50/50 stock/bond portfolio using 500 Index and Total Bond Market as my proxies going all the way back to Total Bond Market’s inception in Dec. 1986.” He tried rebalancing every six months, every year, and every third year along with not rebalancing at all.

This is a flawed analysis of rebalancing.

Rebalancing bonus between stocks and bonds is not for the purpose of boosting returns. Stocks on average earn 6.5% over inflation. Bonds on average earn 3.0% over inflation. The more a portfolio allocates to stocks, the greater its average return should be. And if you start with a 50/50 portfolio, letting the stock side continue to grow out of balance should continually boost returns. Thus I would expect in Wiener’s case study the “not rebalancing at all” case to do the best. Oddly enough that is not what he found.

His statistics showed that the best strategy was annual rebalancing which had both the greatest return as well as the second lowest volatility. The amount was small. From this he concluded that “rebalancing’s benefits are minimal.”

Again, I am surprised he found a rebalancing benefit between stocks and bonds at all. You don’t allocate anything to bonds in order to boost returns. Yes, there are times, usually very volatile times, when a small allocation to bonds can help boost returns. But normally any allocation to bonds is done for the purpose of withdrawals, not to boost returns.

Wiener did not test his study with a 50/50 allocation between the S&P 500 Index (US Stocks) and the MSCI EAFE Index (Foreign Developed Countries), or between MSCI EAFE Index (Foreign Developed Countries) and the MSCI Emerging Market Index.

Weiner went on in the article to try other methods of rebalancing, but he never returned to challenge the flaw in his initial set up of what it was he was rebalancing.

For those who want to understand rebalancing better, I’ve written a five part series of articles on the wisdom of rebalancing which describes in detail the wisdom of rebalancing. Here is each of those five articles and the rule of thumb for investing:

Investment Strategies Part 1: Rebalance into Stable Investments in an Appreciating Market:

  • There is no rebalancing bonus between stocks and bonds.
  • Stocks average 6.5% over inflation and bonds average 3% over inflation.
  • For most allocations, the more you put in stocks the greater the return and the greater the volatility.
  • The reason not to put everything in stocks is because withdrawals during retirement during downturns in the market can jeopardize the success of your retirement.
  • Therefore put 5 to 7 years of safe spending in bonds.

Investment Strategies Part 2: Use Correlation to Define Asset Classes:

  • Investment Advisors may define asset classes differently.
  • Correlation is the measure of how two different investments either move in sync with one another (1.0) or opposite from one another (-1.0).
  • A low correlation between asset classes provides the benefits of diversification and rebalancing.
  • Therefore it is best to use correlation to help define what constitutes an asset class and what is better thought of as a subcategory.
  • Correlation is calculated over a specific time period and when the dollar moves the correlation of everything goes to 1.0.
  • As a result, the best you can do is look at the lowest that the correlation between two categories can drop to in order to determine asset classes.

Investment Strategies Part 3: Rebalance Regularly Between Asset Classes and Subcategories:

  • A rebalancing bonus is a mathematical calculation.
  • The rebalancing bonus is dependent on low correlation and high volatility.
  • When one asset category has a higher rate of return, the bonus of including the category with the lower rate of return is often only reduced volatility.
  • As a result, rebalancing works best with high-volatility, low-correlation assets with similar long-term returns.

Investment Strategies Part 4: Don’t Rebalance at the Sector Level:

  • Sectors of the economy can be shrinking or contracting in the economy.
  • There is no easy way to determine the allocation to each sector in a way that you should continue to rebalance back to that allocation despite what the economy is doing.
  • Therefore rebalancing between sectors of the economy is as likely to have a penalty as a bonus.

Investment Strategies Part 5: In Defense of Diversification:

  • Since everything is denominated in dollars, when the value of a dollar moves everything moves in sync and appears to have a correlation of 1.0.
  • This is what happened during the credit crisis of 2008 as the demand for dollars to deleverage became very high.
  • This shortfall is not an argument against the benefits of diversification.

Photo by billybear used here under Flickr Creative Commons.

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President, CFP®, AIF®, AAMS®

David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. In addition to his financial writing, David is a co-author of The Haunting of Bob Cratchit.