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Why We Don’t Rebalance

by Jason Hsu

Why We Don’t Rebalance Splash image

For investors, the $1 million question is, “Why don’t all of us rebalance?”

Research shows compellingly the long-term benefit of rebalancing, yet anecdotal evidence suggests that most investors do not rebalance their portfolios—that is, buy assets that have become cheap and sell assets that have become expensive. In fact, many investors do the exact opposite!

Why is it so hard for investors to rebalance? The answer is less about “behavioral mistakes” than the fact that “rational” individuals care more about other things than simply maximizing investment returns. Perfectly rational individuals exhibit changing risk aversion that makes it hard for them to rebalance into high return assets that have suffered steep recent price declines. The unwillingness to buy low and sell high is not characteristic of just individual investors who are unaware of the finance literature and market history. Very sophisticated institutional investors, advised by investment consultants and academics, are prone to the very same behavior.

This article, which was originally published in the July 2012 Research Affiliates’ Fundamentals newsletter, reviews the empirical evidence for return improvement from rebalancing, as well as the reasons why most sensible investors don’t do it.

Why Rebalance?

A significant body of financial research has shown that asset classes exhibit long-horizon price mean-reversion. When an asset class falls in price, resulting in a more attractive valuation level relative to history, it is more likely to experience high subsequent returns. For example, when the S&P 500 index falls in price, its dividend yield increases; empirically the subsequent five-year return on the S&P 500 tends to be significantly above average. Similarly, when corporate bond prices fall as credit spreads blow out, the forward return on corporate bonds increases. Price mean-reversion in asset returns suggests that a disciplined rebalancing approach to asset allocation that responds to changing valuation levels would improve portfolio returns in the long run.

So, if “buy low and sell high” works so well, why don’t investors rebalance? Research suggests that our risk attitude interacts in a predictable way with our wealth level and thereby influences our decision-making with respect to rebalancing. Specifically, investors tend to become more risk-averse and, therefore, unwilling to add risk to their portfolios despite lower prices when their portfolio wealth declines. Investors tend to become more risk-seeking and, therefore, more willing to speculate even at high prices when their portfolio wealth increases.

The following illustration provides an intuitive way to understand this behavior. Consider a household with a certain level of income and wealth. This household anchors its standard of living (expenditure pattern) to its income/wealth profile. When positive fundamental shocks (such as a surprise jump in gross domestic product or corporate earnings growth) hit the market, stock prices go up. A string of positive economic surprises, and the resulting equity bull market, can lead to a substantial increase in investor wealth. This market environment is also generally characterized by low unemployment, strong wage increases, healthy bonuses and appreciation in real estate value.

The investment gain coupled with stronger income affords the household the “option” to take an extra vacation, upgrade to a larger house and/or retire earlier. The higher household income and the substantial increase in wealth also allow the household to take on more risk without affecting its standard of living and retirement prospects. The investor compartmentalizes the newfound wealth as a “windfall.” Often, the investor speculates with this windfall; this is not dissimilar to the increase in aggressive betting when a casino gambler has just won big and is playing with “the house’s money.” The house money effect can explain why investors do not rebalance away from equities after a major rally, even though higher prices significantly reduce expected forward returns.

On the flip side, when there is a string of negative economic surprises, the resulting bear market can destroy substantial household wealth. Bear markets often coincide with high unemployment, weak wages, no bonuses and stagnant-to-declining home values. The decline in income and loss of wealth pose appreciable threats to the household’s standard of living. Indeed, any further loss in portfolio value could cause a permanent and very unpleasant adjustment to the household’s quality of life and retirement planning. A severe decline might mean the investor is no longer able to afford college tuition for his children or, worse, that he needs to sell his house or delay retirement significantly. These events do not make for comfortable bedside conversations at an already stressful time. “Honey, I lost an additional $50,000 because I rebalanced and bought more Bank of America (BAC) on its way down. But don’t worry, the price is likely to mean-revert higher soon.” This isn’t a good thing to say when one already has to cancel that romantic European getaway and has no prospect of a year-end bonus. Unsurprisingly, the investor becomes very risk-averse to further volatility in his wealth and is unwilling to take on investment risk even in very attractively priced assets.

Similar behaviors are found among investment fiduciaries. After large market declines (often followed by lowered interest rates, which boost the market value of pension liabilities), pension funds are more likely to become underfunded. Any further downside volatility to the funding ratio could trigger a mandatory contribution or other adverse regulatory actions. In addition, it is also human tendency to be more blame-oriented during a time of stress, made worse by significant loss in personal wealth. This environment does not tolerate short-term negative outcomes even when they result from a sensible investment with high long-term returns. As a result, fiduciaries also tend to be significantly more risk-averse after a bear market and are generally unwilling to rebalance into risky assets after significant price declines despite the better returns.

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Risk Premium or Free Lunch?

There is strong evidence that naïve investors chase trends—for example, they over-extrapolate a recent string of good or bad news and/or follow prices in an uninformed way. This behavior results in irrational buying and selling, which pushes prices away from their rational valuations and creates “alpha” opportunities for others. The truth is, supposedly sophisticated investors do not behave in a meaningfully different way; contrary to the standard claim, they are not better positioned to capture the potential “free lunch.” Time-varying risk aversion is a natural consequence of the business cycle and the associated equity market bull/bear cycle. Rational investors are too risk-averse in down markets to buy stocks at attractive prices and too risk-seeking in up markets to reduce their equity allocation in response to unattractive forward returns. As a result, the pattern of price mean-reversion in equities (and more broadly in all asset classes) does not become arbitraged away by “rational” investors.

Price mean-reversion in asset class returns generates what is often referred to as rebalancing return. When investors rebalance into fallen assets and away from safe assets, they also rebalance into high forward-return assets and away from low forward-return assets. This practice generates better portfolio performance over time than a buy-and-hold approach. Given herding and over-extrapolation by naïve investors as well as time-varying risk aversion for rational investors, the rebalancing return can be thought of as part “free lunch” and part “risk premium.” The free lunch comes from trading against behavioral mistakes of unsophisticated investors. The “risk premium” comes from bearing the discomfort associated with taking on more risk when one is least able to bear risk.

Should You Rebalance?

If the $1 million question is, “Why don’t investors rebalance?” then the $5 million question is, “Should you rebalance?” Statistically, you are likely to outperform in the long run if you rebalance in response to major price movements. However, when you buy risky assets during economic distress, there is a significant probability that, in the interim, your portfolio may suffer a greater decline than if you didn’t rebalance. In the short run, your probability of being fired as a fiduciary, of being blamed by clients you advise and, most importantly, of marital strife, becomes moderately higher when you rebalance.

So who should rebalance? If you have over-saved significantly relative to your spending needs, rebalancing and the associated increase in short-term risk would not threaten your standard of living. For aggressive savers, rebalancing is a fantastic strategy. If you work at an organization that is truly concerned only about long-term investment performance and unconcerned by (and holds you above blame for) the short-term fluctuations, then rebalancing is a fantastic strategy for you. Other than that, one should best remember Keynes’s greatest insight (modified here for our purpose): The market can stay irrational longer than you or I can remain employed, or for that matter, happily married.

Therefore, it isn’t obvious that one “would” rebalance even if one were convinced of the price mean-reversion tendency in assets. European equities, specifically financials, are heavily discounted—providing unprecedented yields and high expected returns. Would you rebalance with conviction into European equities? Into financials? The trepidation we experience associated with these investments doesn’t stem from our superior ability to forecast a disorderly breakup of the European Union. After all, prices are largely disciplined by Wall Street proprietary traders and hedge fund managers and reflect all relevant risk scenarios and probabilities.

We don’t rebalance because we are first and foremost human beings with a multitude of considerations before we are investors and fiduciaries optimizing for long-term expected returns. This is perhaps why it has become fashionable for wise men to recommend “institutionalized rebalancing”—making rebalancing part of pension fund governance instead of leaving the decision to investment officers and fund trustees. Despite all of the intellect and adaptive learning that we bring to bear, sadly, human beings with our changing risk aversion are poorly suited as stewards for managing long-term returns.

Jason Hsu is chief investment officer at Research Affiliates LLC and an adjunct professor of finance at the UCLA Anderson Business School.


Discussion

David from PA posted about 1 year ago:

Tax consequences do play a role in rebalancing. by taking gains in an up market to buy lower yielding investments is indeed difficult.


Edward Wiltgen from SD posted about 1 year ago:

I think re-evaluation every 6 mos is worth consideration because the market tends to run more positive from Nov to May and more negative May to Nov.


Mark Henwood from CA posted about 1 year ago:

I find the consequences of taxes to be a major disincentive to rebalancing, particularly when the effect of rebalancing on portfolio return is so small.


Norman Fulton from OH posted about 1 year ago:

Losses from taxes is the number one problem with rebalancing as mentioned above. The second problem is loss of income from the dividends of the sold stocks. If AAII publishes this article again, it would be good to add discussion of these aspects. I really don't want to trade stocks yielding say 15% with stocks yielding 3% or bonds yielding 0%


Jon Silverberg from NY posted about 1 year ago:

It would be useful for Mr. Rotblut and Mr. Hsu to have a give and take about the conclusions of each other's articles and the implications for a strategy going forward.


Jeff Ransom from NJ posted about 1 year ago:

Higher tax impacts from selling appreciated equities are further "aggravated" by the progressive nature of those increases: bracket creep and the AMT, which is still unresponsive to inflation. As in any strategy, blind compliance to reallocation must be moderated by specific, real-world details, and some personal financial timing is indicated. Tools which take into account all these effects would be welcomed aids to compare various tactics possible at any point.


Stephen from PA posted about 1 year ago:

Re-balancing sounds good as a strategy, but I do not find it offers much for me. As a retiree, I need dividends from stocks and interest from bonds. Even if a stock becomes "over-priced", but it pays a reasonable dividend, I see no reason to sell it. However, if the dividend is reduced or deleted, that stock is mostly or altogether gone. It is more important to me to distribute my stocks over a wide variety of industries and companies than to worry about re-balancing. For bonds, I don't play "ladder" games. I am looking for reasonably priced bonds with decent yields, and I am content to buy long bonds. At my age (74), I cannot worry about paying a premium today, then suffering a loss when the bond matures. I probably won't be around anyway. In any event, I have stopped buying bonds for now, because I do feel that interest rates will begin to rise soon. Many or most may not agree with my investment strategies, but they have worked for me over many years, in good times and bad.


Dave Gilmer from WA posted about 1 year ago:

Stephen,
I agree pretty much with your strategy, but I stress more dividends for income and index funds for equity growth. The rebalance strategy usually works better if you have a bond/stock allocation, but mainly to keep your risk constant and not really as a way to improve your total return.


John Borden from CA posted about 1 year ago:

Other than some comments above, I seldom hear any discussion about the tax implications of rebalancing a taxable portfolio. IRAs are easy to rebalance. Not so with taxable portfolios. Last year I fell for the "you must rebalance yearly" mantra. I sold several ETFs that had done well but fell out of favor with the market. The sale resulted in a 15% federal tax in addition to a 9.3% state tax (California treats L.T. capital gains as ordinary income). That was a 24.3% tax "hit" on my gain. Some say "pay the taxes with other money". Excuse me. That "other money" was potential investment money. I am now researching a buy-and-hold taxable portfolio anchored with a Vanguard S&P 500 fund. Any thoughts?


Paul Hopler from VA posted about 1 year ago:

Charles Rotblut a vice president at AAII and editor of the AAII Journal made clear that rebalancing will reduce risk (variability) and without re-balancing stocks will overwhelm bonds. However, if variability is not a problem, and the trend is to stocks, then why on earth would anyone rebalance. If I get 10% variability and 12% growth is this not better then 1% percent variability and 11% growth?


Robert Hooke from CA posted about 1 year ago:

Tax consequences can be even greater due to the AMT.
I calculated the following for a high income ($200k) couple with a marginal rate of 32.5% including AMT.:
Income tax %:
short term gains 32.5% + 9.3% CA = 41.5%
long term gains 21.5% + 9.3%= 30.8%
Qualified Dividends 21.5% + 9.3% = 30.8%
all other taxable income 32.5% + 9.3% = 41.5%

I'd think long & hard before "rebalancing" especially for high dividend stocks.


William Lawrence from NY posted about 1 year ago:

I'm with Stephen (who is in my age cohort) on this. I have mostly good old boring dividend-paying stocks that don't exhibit a whole lot of volatility. But since I don't draw down on principal (or on principle) I frankly don't worry about volatility, and the rather marginal advantage afforded by rebalancing after taxes doesn't make it any more attractive than my (mostly) buy and hold approach.


Crescentia Szerlip from CA posted about 1 year ago:

Well, aside from tax consequences, which are a major factor, it's hard to grit your teeth and sell into a rising market, and you have no assurance that your replacement stocks will do well.


Dave Gilmer from WA posted about 1 year ago:

The opening comment, "why don't we rebalance," seems a little mis-leading to me. Anyone who is contributing to their 401k or other account on a monthly basis is certainly rebalancing their account by the simple mechanism of dollar cost averaging.

I am using good old boring dividend paying stocks as well in retirement for 100% of my income.

I have always thought that the benefits of rebalancing were dubious at best - in most cases this means trading higher return equities for lower return bonds. It does keep your risk profile intact, but it also lowers your long term returns.

fd


Harry McCullough from PA posted about 1 year ago:

Apparently the consensus here is tax rates, already historically low, are going to go down. So I guess there also agreement that ROTH's are a bad idea.
Doesn't rebalancing play a role in maintaining not just an allocation but also diversification? The biggest reason for not selling Enron was they didn't want to pay the big tax bill.
I don't hear it much, but according to the text books, taxes should take a back seat to investment decisions.


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