Portfolio Rebalancing Revisited
December 29, 2015
by Michael Kitces
Qualivian Investment Partners Up 30% YTD; Long ORLY Thesis
Qualivian Investment Partners commentary for the second quarter ended July 30, 2020. Q2 2020 hedge fund letters, conferences and more “Short-term investors will accept a 20% gain because they didn’t spend the time to develop the conviction and foresight to see the next 500%.” - Ian Cassell Executive Summary Readers of investment letters fall into Read More
Earlier this year, in a series of articles (Does Rebalancing Really Pay Off?? and Does Rebalancing Reduce Risk?), Michael Edesess argued that rebalancing neither increases returns nor reduces risk, although in the latter case his conclusion was based on one’s definition of risk. However, it turns out that the debate on whether there is value in rebalancing – in terms of return enhancement and/or risk management benefits – actually depends on the similarity (or lack thereof) of the returns between the available investments in the first place.
The conventional view of portfolio rebalancing is that it enhances long-term returns by periodically selling the investments that are up (and overweighted) to buy those that are down (and underweighted), in the process of realigning the portfolio to its original target allocation.
Yet the reality is that because most investments go up far more often than they go down, systematic rebalancing is more likely to consistently liquidate the best-performing investments to buy ones with lower returns instead – especially when rebalancing across investments that have very significant return differences in the first place (e.g., rebalancing from stocks into bonds).
As a result, rebalancing may be helpful as a risk management strategy – otherwise higher-returning stocks would compound to the point that they are significantly overweighted relative to lower-returning bonds – but it’s only when rebalancing amongst investments with similar returns in the first place that rebalancing can provide a return-enhancement potential.
In other words, it’s crucial to recognize the role that rebalancing really does – and does not – play in a long-term portfolio. For the typical diversified stock/bond investor, the expectation should be that rebalancing will likely reduce long-term portfolio returns, but that it may be worthwhile anyway because even if returns are lower, risk-adjusted returns may be improved if the risk is reduced by even more. On the other hand, in some cases returns really can be enhanced as well, but likely only when rebalancing across similar-return investments, such as amongst sub-categories of equities.
How portfolio rebalancing can reduce long-term returns
The classic purpose of portfolio rebalancing is to realign the balance of investments in a portfolio, generally to stay in accordance with its original target weightings. In a world where asset classes have materially different long-term returns, this is critical to ensuring the portfolio does not compound to the point of violating the investor’s risk tolerance.
For instance, the long-term nominal return on stocks is about 10% per year and for bonds it is only 5%. As a result of the different compounding rates, this means the percentage of the portfolio allocated to equities will become larger and larger over time.
As shown above, the “bad news” is that over time, what starts out as a 50/50 portfolio drifts to 67/33 by 15 years, and nearly 80/20 after 30 years! Thus, an investor’s equity exposure will become far greater than what was originally intended and perhaps greater than what he or she can tolerate.
Yet the reality is that regular rebalancing to keep the client’s equity exposure from drifting too high leads cumulative portfolio returns to be reduced, not enhanced! After all, rebalancing will systematically sell the higher-returning asset (stocks) to buy more of the lower-returning asset (bonds), which just drags down the long-term return.