Like flossing, we’re told that we need to rebalance because it’s good for us. But does rebalancing improve returns? Like many financial questions, the unsatisfying answer is “it depends”. Today we are going to take a deeper dive into rebalancing, when it works, when it doesn’t, and why it is still a good idea.
You might choose a 60/40 allocation (60% stocks, 40% bonds) because that portfolio has certain risk and return characteristics which fit your needs. Over time, as the market moves, your portfolio is likely to diverge from its original allocation; rebalancing is placing the trades to restore your original 60/40 allocation.
If we assume that stocks grow at 8% and bonds at 3%, what would happen if you did not rebalance? With a higher return, the stocks would become a bigger portion of the portfolio. In fact, after 30 years, your allocation would have shifted from 60/40 to 86/14. It should be noted right at the outset that under the straight-line assumption of stocks outperforming bonds, your performance would be higher by never rebalancing. Selling stocks to maintain a 40% weighting in bonds would slow your growth.
However, if you wanted an aggressive portfolio, you wouldn’t have started with a 60/40 allocation. We should recognize from the outset that the primary goal of rebalancing is not to enhance returns but to maintain a target allocation.
But since the stock market does not move in a straight line and give us exactly 8% returns every year, rebalancing may have a benefit in taking advantage of temporary price disruptions. If the the market tumbles, rebalancing will buy stocks at those low prices. And when the market runs up and is high, rebalancing can sell overvalued stocks and add to the safety of bonds.
What is key to rebalancing, but poorly understood by investors, is that the frequency of rebalancing is a crucial consideration. There’s not just one way to rebalance. Let’s consider a couple of scenarios.
1) In a trending market, where stocks move in one direction for a long time, the more frequently you rebalance, the worse return you create.
For example, let’s imagine a Bull Market where stocks grow by 10% each quarter, and bonds only gain 0.75% per quarter. If you started with $100,000 in a 60/40 portfolio, and did nothing, you would have $129,059 at the end of one year. But if you rebalanced each quarter, your return would be $127,682. Here, rebalancing quarterly would have reduced your returns by $1,376.
But you thought rebalancing was supposed to enhance returns? When a market trend continues for a long period, you would be better off sticking with the trend, rather than rebalancing against the trend.
2) Interestingly, rebalancing also makes returns worse in prolonged bear markets, too.
Same situation: 60/40 portfolio with $100,000. Now let’s imagine a one-year Bear Market where stocks fall by 10% per quarter and bonds gain 0.75% per quarter. Without rebalancing, your portfolio would fall from $100,000 to $80.579. If you rebalanced each quarter, you would have made things even worse, with a drop from $100,000 to $79,076. Rebalancing would have extended your losses by $1,503, or 1.87%.
By rebalancing in a prolonged Bear Market, you were adding to stocks, even as they continued to lose value.
3) While rebalancing hurts returns in directional markets, it can improve returns in markets which are fluctuating. In this third example (still $100,000 in a 60/40 allocation), we assume that bonds return 0.75% per quarter, but that stocks go down 10%, then up 10%, then down 10% and then up 10%.
After one year, with no rebalancing, you’d have $100,019. If you rebalanced quarterly, you would have $100,482. That’s a nice difference in a basically flat market. While rebalancing hurts returns if there is a steady trend, it can improve returns when markets vacillate between positive and negative periods.
So what do we do? Not rebalancing (ever) is not a good choice because you will diverge from your risk preferences. We try to strike a balance in our rebalance frequency by doing it only once a year, and only when a position deviates by more than 5% from target levels.
By rebalancing annually, we allow for longer trends, since Bull or Bear markets can certainly last for at least 12 months. So if you see other firms that brag about rebalancing monthly or quarterly, please understand that more frequent rebalancing is not necessarily better or any guarantee that it will increase returns. As we have shown, there are reasons why more frequent rebalancing could actually make things worse in a Bear Market, which is right when you would want the most defense.
Additionally, we need to consider the costs of rebalancing. Besides transaction costs, in a taxable account, short-term gains are taxed as ordinary income. We hold our positions for at least 12 months before rebalancing to get preferential long-term rates. More frequent rebalancing could be creating an unnecessary tax bill.
With extremely low yields today, it may make sense for some young, aggressive investors to consider being 100% in stocks. Then rather than focusing on rebalancing, you can take advantage of market drops by dollar cost averaging with new purchases. However, even in a 100% stock portfolio, you still have target weights in categories such as Large Cap, Small Cap, International, Emerging Markets, Real Estate, etc. And often it still makes sense to rebalance when one of those categories has a large move up or down.
Once you have accumulated some wealth, whether that is $300,000 or $3 million, you really have to think about how you would feel if the market fell by 50%. From a behavioral perspective, having a target allocation and a rebalancing process means that you have created a framework, a discipline, for how you will respond to the inevitable Bull and Bear market cycles. And the process of rebalancing – to buy low and sell high – is definitely preferable to our innate response, which is often to buy when there is euphoria and to throw in the towel when the market plunges.
Hopefully, you now understand that rebalancing is not a guarantee to enhance returns. In fluctuating markets, it can help you buy low and sell high. But in long-trending markets, the more frequently you rebalance, the more you will reduce your returns, whether it is a Bull Market or a Bear Market. So we can’t blindly just say that rebalancing is good, we have to use it intelligently.
