Portfolio Rebalancing: The Ins and Outs

Roger Nusbaum submits: A bit about rebalancing. There was a question about it, and a good post about it on Seeking Alpha by James Picerno.

Having the balance you think is proper is of course important, but I think that the frequency with which rebalancing needs to occur is lower than most people think.

Taking the data from Picerno's article, which goes through April 6, the Russell 3000 (IWV) was up 11.55% for 12 months, iShares EAFE (EFA) was up 19.61% and iShares Lehman Aggregate Bond ETF (AGG) was up 6.07%.

Taking these three as a lazy portfolio hypothetically weighted at $45,000 in IWV, $25,000 in EFA and $30,000 in AGG on April 6, 2006 and using James' numbers, IWV is worth $50,197.50, EFA is worth $29,902.50 and AGG is worth $31, 821.00 -- for a total of $111,921.00 on April 6, 2007.

This leaves IWV with a 44.8% weight versus a target of 45%, EFA at 26.71% weight versus a target of 25% and AGG at 28.43% versus a target of 30%. To rebalance you need to buy $220 dollars of IWV which is about three shares, sell $1700 of EFA which is 22 shares and buy $1500 of AGG or 15 shares.

I can't say you should not rebalance at this level, but I wouldn't do it. Keep in mind this is one year of results and the need to rebalance is, at a minimum, questionable.

Here's a novel concept: Rebalance as the market action of your holdings dictate, regardless of the calendar. I took action yesterday with a stop order of 1/3 of the position for a stock that has been white hot of late, which serves as a rebalance of sorts. The trend is seems to be up so I don't want to sell. It has grown to be fairly large, and if it turns I will be cutting back at a price that seems high.

IWV vs EFA vs AGG -- 1 year chart

Comments

[David Barsan_:]

so do you have parameters in place that say if XYZ was originally at 3% of the portfolio, but if it gets X% above or below that, we rebalance; or is it more of a non-standardized policy?

2007 Apr 11 04:10 PM

[Roger Nusbaum:]

it is non-standardized. I tend to think that not every single situation is the <em>exactly</... same. Some stock don't lend themselves stop orders and some do for example. There are just a lot of moving parts with this sort of thing, IMO.

2007 Apr 13 01:25 AM

[Beta Hog:]

There are two 'standard' ways to re-balance ... either (1) percentage deviation away from a pre-defined percentage weighting or (2) on a pre-set, regular calandar cycle (say, quarterly). There is, however, an even better way but it involves a diciplined Tactical Asset Allocation (TAA) process that operates within a rigorous Strategic Asset Allocation (SAA). Anyone interested in what this involves may contact me directly ([e-mail])

2007 Apr 11 09:10 PM

[Tristan Yates:]

BTW Rebalancing is done primarily to decrease volatility, not improve returns. Imagine a thought experiment where you rebalance a diversified portfolio every day and don't pay any transaction costs to do so. You do that for a year and then check your portfolio. Some stocks have gone up, and you now have fewer shares of those stocks. Other stocks have gone down, and you have more shares of those stocks.

At the end of the year, it is possible that rebalancing helped your returns or hurt your returns. If one stock appreciated faster than the others, and your rebalancing forced you to sell shares in it and put them into poor performing stocks, then you probably did worse than if you had not rebalanced.

But when you look at your average daily returns thoughout the year, there will be tremendous consistency, especially if your stocks aren't very correlated. Every day you are perfectly diversified, and your portfolio moved just a little, either up or down. Your sharpe ratio will be lower than if you had simply bought and held the stocks based upon your starting allocations.

Note that rebalancing can also work very well if one of your assets is cash or bonds because it forces you to reinvest some of your gains in risky assets into risk-free assets. This can cut your volatility down tremendously.

2007 Apr 29 05:13 PM

[David Jackson:]

This discussion of Rebalancing Rules that also suggests that investors should rebalance based on allocation, not on time. Look also at the suggestion that investors should wait for asset class allocation overshoot before rebalancing. Would love to know people's thoughts on that.

2007 Apr 30 03:04 AM