What does it mean to rebalance your portfolio, and how often should you be doing it?
An important part about investing is choosing how much of your money will go into each asset within your portfolio. For a simple explanation, let's say you want to have 70% of your portfolio allocated to stocks, and 30% to bonds. Your goal would be to maintain that 70/30 balance. Most portfolios have more than just one stock fund and one bond fund, so there is often a further balancing act within each category of fund.
Portfolios are rebalanced when the allocations are no longer what they started as. This is a natural occurrence, because the prices of stocks and bonds will always fluctuate, and they will not move in perfect sync with the other positions in your portfolio. So over time, your once 70/30 allocation could end up looking like a 80/20, or a 60/40. To stay in line with your goals, one would rebalance, which means selling some of the overweighted portion, and using the cash to buy more of the underweighted assets, until your portfolio is back to its target allocation.
There are quite a few theories addressing rebalancing. Some suggest monthly, quarterly or annual rebalancing. Others suggest rebalancing based on how far off the asset class has drifted from the target. In the later, rebalancing can be triggered by setting up a rule to rebalance when the positions weight drifts by more than a tolerance value, which can be 10%, 20%, 25%, 50%, etc. ...
When should you rebalance your portfolio, and what strategy is best?
On a journey to determine which rebalancing option is better, we constructed a sample moderate portfolio and tested different options over the most recent 20-year period. This allowed us to review the portfolio during the bull markets as well as the bear markets in 2000-2002 and 2007-2008 periods.
In short, our conclusion is in line with what many research papers have concluded. There is no evidence that frequent rebalancing, including even annual rebalancing, adds value to the portfolio performance.
After testing quarterly, annually, and with target weight rules, we found that rebalancing proves the most effective when one or more of the positions weights drift by more than 50% of the tolerance value, providing an increased annualized rate of return by 0.30% over a 20-year period and 0.46% over a 10-year period*. In other words, in the last 20 years, a hypothetical investment of $100,000 grew to $402,153 in the portfolio that was rebalanced annually, versus $426,950 in the portfolio that was rebalanced when one of more positions drifted by more than 50% from the target allocation. We’ll call that the “Trigger Rebalanced Portfolio”.
A new approach to rebalancing, the "Trigger Rebalanced Portfolio"
In our tests, the Trigger Rebalanced Portfolio was only rebalanced 6 times in the last 20 years, saving a good amount in transaction costs compared to the annually rebalanced portfolio, which was rebalanced 20 times.
It is important to note that the target allocation in the sample moderate portfolio has been set to include 70% equities and 30% bonds.
In our test, the Trigger Rebalanced Portfolio with the trigger set for 50%, drifted to an allocation as high as 81% in equities and 19% in bonds and as low as 62.53% in equities and 37.47% in bonds. To implement this strategy, the investor must be comfortable with the dynamically changing allocation and therefore a risk level in the portfolio.
For example, from Jan 1, 2008 to Dec 31, 2008, the Trigger Rebalanced Portfolio declined 23.5%, and the annually rebalanced portfolio 25.04%. If the allocation were to drift to 80% in equities at “the wrong time”, the portfolio could have declined 29.25%. This is absolutely not an attempt to predict the future, rather just a reminder that allowing the portfolio to drift may increase risk.
From the longer-term perspective, over the 20-year period, risk as measured by standard deviation was almost the same.
The Trigger Rebalanced Portfolio had a standard deviation of 11.0%, only .1% higher than the Annually Rebalanced Portfolio at 10.9%.
Over the last 10 years, the risk has been higher. The Trigger Rebalanced Portfolio had 10.5% standard deviation, and the annually rebalanced portfolio 9.8%.
How rebalancing could impact your returns
To summarize, the portfolio with the target allocation of 30% to bonds, may drift up to 50% in either direction, or allocate anywhere between 20% and 45% to bonds, and after that point the rebalance is triggered. Timing of the rebalances in our sample portfolio may have attributed to improved results.
Coincidently, the drawdown in the 2007-2008 and 2000-2002 crisis was reduced by 1-2% as the rebalances had been triggered to lower equity positions close to the peak of the bull market and the reverse effect had been achieved when the equity prices were low, and the rebalances were triggered to sell a portion of the bond portfolio and buy more equities before the recovery.
Transaction cost savings are not accounted for in the calculation and can provide additional value.
While there are firms that recommend rebalancing frequently, we shouldn’t let the feeling of needing to do “something” get in the way of simply allowing the portfolio to capture market returns. There is no evidence that frequent rebalancing adds value.
Our findings are also in line with the facts found in the research paper published in October 2008 by DFA titled “Rebalancing and Returns” authored by Marlena Lee, Co-Head of Research: “A rebalancing strategy that tolerates a greater amount of drift will typically have higher expected returns and be exposed to greater risk compared to rebalancing strategies that allow less drift.” Marlena Lee analyzed 82 years of data, her conclusion: “Over the entire 82-year sample, it is clear that the rebalanced portfolio had no significant advantage over the portfolios rebalanced less frequently. It would be premature to declare the existence of positive rebalancing return benefits using 10 to 20 years of data because the period is too short and the data is too volatile to distinguish higher expected returns from luck.”
“…there is no easy one-size-fits-all rebalancing solution. Rebalancing decisions should be driven by the need to maintain an allocation with a risk and return profile appropriate for each investor. The optimal rebalancing strategy will differ for each investor, depending on their unique sensitivities to deviations from the target allocation, transaction frequency, and tax costs.”
At OCWM we review portfolios quarterly and rebalance only when the target weight in the asset classes have drifted sufficiently to justify the transaction cost, potential tax consequences and to not impact probability of future returns and risk level established in the Investment Policy Statement for each client.
If you are interested in learning more about rebalancing, or not rebalancing your portfolio, we would love to answer any questions you might have. You can contact us here, and a member from our team will get back with you as soon as possible.
If you are interested in seeing if our rebalancing approach could benefit your portfolio, we are offering a free Test Drive for our Financial and Retirement Planning Portal, offered at no cost and no obligation. You can click here to learn more, or feel free to contact us with any questions about setting up your free Test Drive.