Rebalancing Can Be Hazardous to Your Portfolio

by: Phil DeMuth

An excerpt from the new book Yes, You Can Supercharge Your Portfolio - reprinted with permission of authors Ben Stein & Philip DeMuth and publisher:

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Yes, You Can Supercharge Your Portfolio

Portfolio Rebalancing

The financial services industry loves to tout portfolio rebalancing as a value-adding strategy. The idea is that every year we should sell a little of that 12 months’ winners and use them to buy the current losers so that we bring our portfolios back into alignment with their original specs. Thus, if we had a portfolio of 60 percent stocks and 40 percent bonds initially, and at the end of the year find ourselves with 62 percent stocks and 38 percent bonds, we’d sell the extra 2 percent of from the stock side and add it to the bond side. Although it can incur tax and transaction costs, rebalancing is promoted on the idea that it gets us into a righteous “sell high, buy low” discipline.

Most of the studies we’ve read on the topic are either theory-based or derived from simple 60/40 stock/bond portfolios drawn from the historical record. This greatly oversimplifies an important question. We looked at 10,000 Monte Carlo simulations involving complex, seven-asset-class portfolios. We experimented with several calendar-based strategies, rebalancing the portfolios monthly, annually, or never. We also looked at tolerance-based rebalancing approaches: rebalancing when the portfolio wandered 10, 15, and 20 percent from its original allocations. (Your authors are grateful to Chartered Financial Analyst Bill Swerbenski for modifying his Portfolio Survival Simulator to enable us to make these calculations.) The results of these different approaches are all shown in the graph below.

Each triangle in the graph represents a specific rebalancing strategy and its effects on the 10,000 portfolios’ returns and risks. Note especially the “line of best fit” that indicates the average trade-off between risk and return of all these approaches.

The first thing that stands out is that the more frequently we rebalance, the worse our returns. The next obvious point is that, as is commonly observed, rebalancing cuts our risks. What we’d hasten to add, however, is that it doesn’t cut our risks efficiently. Specifically, the most frequently recommended ritual—annual rebalancing—puts our portfolio’s returns-to-risk profile below the efficient frontier.

Tolerance-based approaches, on the other hand, seem to have more merit: Those portfolios that were allowed some leeway to roam before being rebalanced had better risk-adjusted returns (above the line) than those adjusted according to the calendar (below the line).

This shouldn’t be surprising. When we go through this procedure frequently, it just shuffles short-term market noise into our portfolios. But rebalancing only when market action has had a chance to push our portfolios significantly out of alignment allows us to take advantage of market momentum misvaluation effects that aren’t otherwise captured by asset-allocation strategies.

When the obvious costs of rebalancing are pointed out, advocates quickly shift their ground to argue that it’s really being done to control risk. This may be true, if the only risk we’re talking about is standard deviation. But what about the risk of running out of money? The figure below shows how, starting with $1,000 invested across seven asset classes, the worst 5th percentile portfolio out of 10,000 grew after 25 years in the markets when following each of these rebalancing strategies.

Even in this bad-case scenario, overactive realignment costs us money if we’re long-term investors. In sum, one way we can supercharge our long-term returns is by not rebalancing our holdings too often.