Does Portfolio Rebalancing Work?

Traders work on the newl...Investors are generally good about selecting an asset allocation based on their goals, resources and risk tolerance. Unfortunately, when it comes to implementation, many investors react emotionally to news and therefore fail to use market volatility to their advantage.

Perhaps the greatest gift investors can give themselves is a strategy to take the emotion out of important investment decisions. The most time-tested of these strategies is portfolio rebalancing.

Rebalancing means adjusting your holdings, selling stock funds to buy bond funds or vice versa, to maintain your established asset allocation. For example, let’s say your asset allocation is 60% stocks and 40% bonds. If stock prices go up for a few months, your allocation to stocks might rise to 65%. That means you would sell 5% of your equity funds to get back to your desired allocation. By maintaining your asset allocation, you keep your risk level near the point at which you’re most comfortable.

Rebalancing also smooths out investment returns and forces you to “sell high” and “buy low.” When one piece of your portfolio goes up, you may be inclined to put more money in that area since it is clearly doing well. But for the health of your portfolio, you should fight that impulse. As the past 25-years indicate, the best thing you can do is take profits from your winners from time to time.

Rebalancing Comes Out Ahead

The chart below shows two portfolios starting in 1985 and ending in 2010. Both portfolios began with a 60/40 mix of stocks and bonds, using the S&P 500 Index for stocks and the Barclays Aggregate Bond Index for bonds. The difference is that one portfolio was never rebalanced, while the other was rebalanced annually back to its 60/40 target.

For the entire 25 year period, the rebalanced portfolio ended with a higher return: a $10,000 investment became $97,000 vs. $89,000 for the un-rebalanced portfolio. But over these 25 years, there were many times when these two portfolios behaved very differently.

The rebalanced portfolio

  • Came out on top for this period
  • Suffered less during deep declined
  • Captured up to 92% of the upside
The un-rebalanced portfolio

  • Reached as high as 81% in equities
  • Was on top after the late 90’s bull market

During the mostly bullish period from 1986 through August of 2000, for example, the un-rebalanced portfolio had a better return than the rebalanced one.  There simply weren’t any significant bear markets during that 15 year time frame.  But when markets are volatile, the benefits of rebalancing really kick in.

The bottom portion of the chart shows the weight each portfolio held in equities over time. The rebalanced portfolio, shown in blue, stays close to the 60% target, deliberately being brought back to that 60% level at the end of each calendar year. The un-rebalanced, in orange, reached as high as 81% in equities in August 2000, after the wild tech boom pushed stocks to dizzying heights. But because the un-rebalanced portfolio participated more fully in the stock market, it also suffered greater losses in the ensuing downturn. The un-rebalanced portfolio lost 32% in the ensuing 25 months, while the rebalanced one lost just 22%.

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In the more recent downturn of 2007-2009 we see a similar pattern, with the un-rebalanced portfolio losing 37% while the rebalanced lost just 30% from peak to trough.  And the trade-off is also appealing: the un-rebalanced portfolio gained 47.9% on the rebound from March 2009 through the end of 2010, while the rebalanced portfolio gained a close 44.3%. So it lost 80% of the downside but achieved 92% of the upside.

As the table below details, this was a pretty consistent pattern of trade-off during the much of this period:  When the market went down, you would have been better off had you rebalanced each year.  When the market rose, you would not have profited as much, but you would have given up less on the upside than you would have saved on the downside.

Set a Date to Rebalance

One approach is to rebalance when your allocation moves five percent or more from your target. But a simpler approach is to calendar it and make the changes on a predetermined date. And simpler is better since it’s important that you actually follow through and do it.

How often should you rebalance your portfolio? Most research concludes that investors should rebalance at least annually. Many people elect to do so quarterly or even monthly, though most studies indicate the difference in both return and risk is slight whichever frequency you might choose. Some research actually suggests that annual rebalancing can result in slightly better returns than more frequent rebalancing without increasing volatility. Not rebalancing at all, however, will certainly result in a portfolio that, over time, will drift considerably from the original risk target.


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