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Why Does The Rebalancing Bonus Work?

Apr. 12, 2018 2:36 AM ET4 Comments
Cullen Roche profile picture
Cullen Roche

One of the best parts about Twitter is that you can follow super smart people and just read their interactions. For instance, yesterday I was creeping on Jeremiah Lowin, Jake from Econompic and Corey Hoffstein. These are three super smart finance guys who were going back and forth about the rebalancing bonus which was made famous by William Bernstein.

I will let you assess their comments as you wish, but I have a lot to say about rebalancing because it's so central to everything I profess so here's my general thoughts on the idea of a "rebalancing bonus."

The basic idea of a rebalancing bonus is that you will rebalance a portfolio away from higher risk assets when they've gone up in value and rebalance towards lower performing assets. It is, in essence, a systematic way of selling high and buying low. For instance, when your 50/50 stock/bond portfolio grows into 60/40 you want to rebalance back to 50/50 and sell the stocks to rebalance back towards the lower risk and lower performing asset because now you're overexposed to the higher risk asset.¹ That's simple enough. But why does this generate what Bernstein calls a rebalancing bonus?

There's a lot of debate about why this works or whether it works at all. And in fact, the results are quite different in nominal and risk-adjusted terms. If we look at the data since 1940 a portfolio of 50/50 stocks/bonds will do slightly better on a risk-adjusted basis and does 1.5% worse per year when rebalanced.

There's a bunch of interesting elements within these results:

  1. Why is there a risk adjusted rebalancing bonus? The nominal results are obvious - stocks tend to beat bonds so a portfolio that becomes more and more overweight stocks will tend to do better on average. The superior risk adjusted

This article was written by

Cullen Roche profile picture
Mr. Roche is the founder of Discipline Funds, a provider of multi-asset low cost ETFs and financial advisory services. To learn more about Discipline Funds please see:https://disciplinefunds.com/

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Comments (4)

Augustus profile picture
Several years ago I read a pretty good article which analyzed rebalancing methods. As you show, never rebalancing wins on the Returns comparison simply because equities have outperformed bonds over the study period. And you make note that the final result hides many periods of intense pain from the equity drawdown periods.

The recommended method from the paper was rebalance when the largest allocation became 20% overweight. Then rebalance only half way back to the target, somewhat letting the winners continue to run. The original 50/50 would rebalance when it became 60/40 and be reset to 55/45. No consideration of rebalance dates. Sorry I do not have a citation for the research.

Your comment about changing targets based upon an evaluation of which part of the economic cycle is identified does somewhat require the crystal ball. Who really knows how long an expansion can last. More interesting would be to know how the different market psychological evaluations are changing, probably more important than next year's earnings. Expansion of earnings multiples are the source of most gains over a two or three year period.
sleek profile picture

What about taxes?

Part of tax-planning is about deferring taxes to future periods when income is lower. Triggering capital gains by selling stocks at other times can act as a drag on portfolio returns.
Cullen Roche profile picture
Good question. It's all about the trade-off. Incurring small taxable events is better than being in a strategy where you risk taking a huge capital loss because you miscalculated your risk profile.

I think you should only rebalance once every few years though. You need to be super patient and reduce the negative impact of taxes while also maintaining a profile that you can stick with.
I wouldn't ever assume the average manager is Peter Lynch. Rebalancing is an admission of ignorance. Also, I've never heard of continuous dynamic rebalancing, so that ideal is where an intelligent discussion begins before adding capital market microstructure and fee friction into the discussion. The subtitle should be "Making Allocation Foolproof ". But too many fools manage money.
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