This article is a sequel to the series of articles summarizing key findings of my dissertation. Last time, I took a closer look at the optimal number of portfolio holdings and this time I am going to address the most common issues related to portfolio rebalancing. Why is it necessary to rebalance your portfolio? How often should you do so? What are the most effective and sophisticated strategies for portfolio rebalancing and do they pay off?
The rationale for rebalancing
The widely held misconception about the main purpose of portfolio rebalancing is that it enhances portfolio returns. Actually, this can hold true, but only in specific time frames. When markets are significantly volatile, rebalancing tends to boost portfolio returns. According to a research paper by Vanguard, historically, rebalancing after negative market events has been especially favourable for long-term portfolio annualized returns. On the other hand, portfolio rebalancing during trending markets can cut portfolio returns as winning positions are reduced with each rebalancing event and loosing positions are consistently magnified. Hence, the result of rebalancing on portfolio returns is uncertain.
From a portfolio management perspective, the primary objective of portfolio rebalancing is to restore a portfolio`s target risk-return characteristics. At the beginning of every investment management process, investors draft their investment policy statements, which clearly define their general investment goals and constraints including portfolio risk - return characteristics. As some portfolio investments produce different returns over time, some holdings grow faster than other and some may even shrink. As a consequence, the original risk - return characteristics of a portfolio change and may no longer be in line with an investor's goals and preferences.
Portfolio rebalancing based on calendar
In practice, portfolio rebalancing is usually performed according to a predetermined schedule. With a calendar-based rebalancing approach, a rebalancing event is triggered every time the date hits the end or the beginning of a certain period (month, quarter, year) or otherwise intended day. The central question here is: how often should a portfolio be rebalanced? To answer this question, one has to take into consideration particularly three things - covariances among portfolio assets, investor's risk tolerance and rebalancing costs. The more correlated returns of portfolio holdings and the longer the rebalancing period, the higher the risk of portfolio weighs shifting from the target asset allocation. On the other hand, the shorter the rebalancing period, the more rebalancing events and the higher total rebalancing costs incurred. Therefore, portfolio rebalancing is in some sense a trade-off between costs associated with rebalancing and the risk of deviation from the desired asset allocation.
Let`s assume two investors - one is a young natural risk taker and the other is a middle aged man with generally low risk tolerance seeking security. Not only will the portfolios of these investors likely differ in their content, but will also be rebalanced differently. The investor with higher risk tolerance will tend not to be too much bothered by changes in portfolio weights and will therefore tend to rebalance infrequently, while the more cautious investor will prefer to get the risk arising from shifting asset allocation under control and will therefore monitor and rebalance his portfolio more often.
Academic answers on the question of optimal rebalancing period differ. Whereas some studies regard semiannual or annual rebalancing frequency as reasonable (Vanguard; 2010), other papers recommend to rebalance every two to four years because it lets investors take advantage of the market momentum (Dennis, Perfect, Snow and Wiles; 1995).
Back to our two investors from the previous example. Let`s now assume that both investors hold the same portfolio made up of the classic 60/40 asset allocation - 60% equities and 40% bonds. Over the last five years, the less frequently rebalancing investor with higher risk tolerance would have probably achieved higher annualized portfolio return with less effort and lower total rebalancing costs than the cautious, frequently rebalancing, investor. Had the markets been choppy, the efforts and costs incurred by the second investor might have paid off.
Rebalancing by thresholds and with cash flows
Calendar-based rebalancing strategy can be combined with, or even completely replaced by, another common types of rebalancing strategies. First of them is rebalancing by thresholds. With this approach, a rebalancing event is triggered every time portfolio weighs drift off target by a certain percentage threshold (e.g. 5%, 10%). The number of rebalancing events with this method is entirely dependent on the performance of portfolio assets and is therefore more appropriate for a portfolio with a relatively small number of holdings. The more volatile returns of portfolio investments and the smaller the threshold, the greater the likelihood of frequent occurrence of rebalancing events.
For instance, imagine two equally-weighted equity portfolios - one with 20 stocks and the other with 100 stocks - which are rebalanced by a 10% threshold. If all stocks have comparable standard deviations of returns, the portfolio consisting of 100 stocks is likely to generate 5 times more rebalancing events than the portfolio with just 20 stocks. Even though rebalancing by thresholds provides a guarantee that risk-return portfolio profile will not deviate from a predetermined range, it can be very costly in case of large multi-asset-class and multiple holdings portfolios.
A second alternative option is to rebalance with portfolio cash flows such as new capital contributions, realized capital gains, interest payments or dividends. This strategy is often used in the management of retirement portfolios. When new funds are deposited on a retirement account, they are usually invested in the assets that are below their target weight, and likewise, when withdrawals are requested, assets that have risen above their target allocations are sold first.
For example, most regular savers in their working-age in their use monthly retirement account contributions to rebalance their portfolios before making any new investment decisions. When they retire and want to enjoy the money they saved, funds for monthly withdrawals then typically come from proportional sales of assets that above their target weight.
And finally, there are several fairly sophisticated rebalancing models that consider factors such as changes in funding, changing market conditions or transaction costs (see Glen; 2011). However, general use of such strategies is very limited, with only some selected hedge funds and computerized investors applying these rules in practice.
Rebalancing is the art of balance
In an attempt to find an optimal rebalancing strategy, I found out that rebalancing is a highly individual matter. In financial literature, there is ultimately no consensual opinion on portfolio rebalancing. Presumably, the reason for this is that investors generally have their own unique risk tolerance and investment objectives, which are rarely overlapping. Hence, I would say that portfolio rebalancing is to a large extent an art of finding a balance in the context of an individual`s own goals and preferences.
Note: Feel free to check my Twitter, I'll try to share my dissertation on constructing and maintaining an optimal investment portfolio later this year. Your comments and feedback are welcomed and very much appreciated!
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.