Generating Higher Returns with Portfolio Rebalancing
“The market can remain irrational longer than you can remain solvent. (Or employed or happily married).”
In other words:
It’s easy to desire letting your portfolio winners continue to win.
It’s hard to desire purchasing your portfolio losers after they’ve lost.
Yet, this is exactly what rebalancing does.
It’s the process of selling off what’s increased in value and purchasing what’s decreased in value, thereby, keeping your portfolio in line with its original asset allocation.
Fundamentally, this is the process of buying low & selling high.
Which sounds great in theory - but in practice there’s a problem.
Over time, an unbalanced portfolio will generate higher returns than a rebalanced portfolio due to the unbalanced portfolio overweighting risk assets, like stocks, which compensate an investor with higher returns.
So why rebalance in the first place if an unbalanced portfolio will generate an investor with higher returns?
There are two main reasons to lean on:
Your portfolio could drift into asset classes that are riskier than you originally intended; this helps maintain a targeted risk level.
Risk = the uncertainty of your expected return over time.
More conservative investors who demand more certainty in their returns may become overweight in stocks which forces the conservative investor to take on more risk than they want. This added risk creates a more volatile portfolio. When market’s experience volatility, this investor may sell to cash at the wrong time.
A well-designed portfolio is specific to an investor's goals, time horizon, and risk tolerance.
As your portfolio drifts, it no longer aligns with those goals.
So, if you value maintaining your risk tolerance, adhering to your goals, and honoring your time commitments for use of your invested capital:
Rebalancing is a great idea.
That said, how often should you rebalance?
A July 2010 research paper from Vanguard looked specifically at this question.
Figure 6 below looks at data from 1926 - 2009 regarding monthly, quarterly, annually, and never rebalancing on costs of rebalancing, average equity allocation drift over the rebalancing time frame, and impacts on total returns.
Colleen Jaconetti, Francis Kinniry, and Yan Zilbering’s conclusion was as follows:
“Just as there is no universally optimal asset allocation, there is no universally optimal rebalancing strategy. The only clear advantage as far as maintaining a portfolio’s risk-and-return characteristics is that a rebalanced portfolio more closely aligns with the characteristics of the target asset allocation than with a never-rebalanced portfolio. As our analysis shows, the risk-adjusted returns are not meaningfully different whether a portfolio is rebalanced monthly, quarterly, or annually; however, the number of rebalancing events and resulting costs increase significantly. As a result, we conclude that a rebalancing strategy based on reasonable monitoring frequencies (such as annual or semiannual) and reasonable allocation thresholds (variations of 5% or so) is likely to provide sufficient risk control relative to the target asset allocation for most portfolios with broadly diversified stock and bond holdings.”
But this brings up an interesting point which I made bold towards the end of their conclusion that threshold variations of rebalancing may allow for more sufficient risk control.
Provided you’re only rebalancing the portfolio when it drifts outside of the designed threshold, could this also allow for the opportunity of higher returns?
This is exactly what Gobind Daryanani researched in his 2008 research titled, “Opportunistic Rebalancing: A New Paradigm for Wealth Managers”
The hypothesis was rebalancing less frequently but looking more often could present a better opportunity to rebalance.
Their findings supported this as they looked at a 60/40 portfolio and a range of rebalance bands from 0 - 25% in intervals of 5%. They then looked to see if any asset class was out of the balance band at various time thresholds.
Their findings suggested that a 20% tolerance band threshold for each asset class and a 10-day time interval of “looking” to rebalance created the highest return benefit.
This concluded that rebalancing can be used beyond a risk-management tool & has the potential to be used as a return enhancement to portfolio returns.