Portfolio Rebalancing: Observations From 25 Years of Data
Charles Rotblut will speak at the 2015 AAII Investor Conference this fall; go to www.aaii.com/conference for more details.
I now have 25 years of data on rebalancing.
Using Vanguard mutual funds that are available to all individual investors, I have tracked the performance of hypothetical portfolios following AAII’s moderate asset allocation model that could have easily been replicated by individual investors. The results show that rebalancing lowered the level of volatility. At the same time, the risk-reduction strategy enhanced returns, which is a reflection of the last two bear markets and the positive role rebalancing played.
In this article, I review the updated numbers. (No rebalancing was required at the end of 2012.) I also point out an important consideration for retirees holding one fund with comparatively lower long-term rates of return relative to the other funds in their portfolio. Finally, I discuss alternatives and options as well as explain how to rebalance within a specific asset class, such as stocks.
In this article
- A Primer on Rebalancing
- Two Replicable Rebalancing Models
- 25 Years of Return Data
- How Have You Reacted to Bear Markets?
- How to Rebalance
- Rebalancing Within Asset Classes
- Alternatives to Rebalancing
- The Optimal Strategy
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As you review the data and my observations, I want you to look at rebalancing from the context of behavioral finance. Rebalancing is a strategy designed to maintain your long-term portfolio allocations. Unlike strategies designed to maximize your performance, rebalancing strikes a balance between risk and return. Its success comes from both alerting you to buy low and sell high and giving you a strategy for coping with whatever the market throws at you.
A Primer on Rebalancing
As some of you may recall from my article last year, “Portfolio Rebalancing: Diversification, Risk Control and Withdrawals” (March 2012 AAII Journal), rebalancing is the process of shifting your portfolio dollars out of asset classes that are overweighted and into asset classes that are underweighted, according to your personal goals and tolerance for risk. It is a strategy that complements diversification by ensuring that your portfolio does not stray too far from your allocation targets.
Here is a simple example I like to use when discussing rebalancing. Let’s say a portfolio is evenly split between large-cap stocks and long-term Treasury bonds (a 50% allocation to each asset class). After one year, volatile market conditions send stock prices lower and bond prices higher. As a result, the portfolio’s allocation shifts from 50% stocks and 50% bonds to 44% stocks and 56% bonds. Rebalancing would move 6% of the portfolio’s dollars out of bonds (lowering the allocation from 56% to 50%) and into stocks (raising the allocation from 44% to 50%), returning the portfolio to its target allocations.
This process preserves the benefits of diversification, as long-term data from the Ibbotson SBBI Classic Yearbook (Morningstar, 2012) demonstrates. A portfolio that started with the simple allocation of 50% large-cap stocks and 50% long-term government bonds that was never rebalanced eventually evolved into nearly an all-stock portfolio. Over the period of 1926 to 2011, the allocation for such a portfolio evolved to 96.3% stocks and 3.7% bonds. Worse yet, the portfolio became nearly 40% more volatile than it would have been if it had been rebalanced on an annual basis.
Even though the study was conducted over a very long period (1926 to 2011), the lesson is clear: The benefits of diversification will be limited if an investor does not rebalance on a regular basis. Rather, risk will increase, even though a big reason for diversifying is to reduce risk. To put things bluntly, if you think diversification is important, you should also think rebalancing is important. Without periodic rebalancing, diversification fails.
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