Rebalancing is a key portfolio management task.
There are many reasons to rebalance, and you’ll be hard pressed to find a financial professional who recommends skipping this common investment practice. Following are the basics of asset allocation and why rebalancing is so popular.
But also, we’ll discuss why you might want to skip rebalancing.
Asset Allocation Basics
A general investing recommendation is setting up an asset allocation that fits with your age, risk tolerance and time horizon. Then, after a period of time, when the market goes up or down, you can rebalance your investments back to your predetermined asset allocation.
Research has shown that stock market returns are higher in the long run than those of bonds and cash. Although, in exchange for receiving those higher returns, investors must accept greater volatility in the value of the investments.
Since stocks are notoriously more volatile, and bonds are less so, conservative investors will own greater percentages of bonds and cash while aggressive investors will allocate more of their investment dollars to stock market assets.
This information contributes to an investors choice about how to allocate funds among stocks, bond and cash-like investments.
Once the asset allocation decision is made, it’s common practice for individual investors or their financial advisors to periodically re-allocate — or rebalance — their assets back to their original percentages.
For example, 60 year old Karen has a 60% stock and 40% bond target asset allocation. After the run up in stock prices during 2019, her investments are now at 70% stocks and 30% bonds. Upon rebalancing, she’ll sell 10% of her stock holdings and with the proceeds, buy 10% bond investments to return to the 60% stock 40% bond allocation. That activity is called rebalancing.
Financial advisors; robo-advisors like Wealthfront, Betterment and Ally Invest; and individual investors all include rebalancing as part of their investment management to-do list.
Why Rebalance?
Obviously, buying low and selling high makes investment sense. Rebalancing is a disciplined approach to remind you to sell assets that become overvalued and buy more of those that have sunk in value.
A benefit to rebalancing is that your portfolio will be less volatile than if you don’t rebalance. Also, you don’t know in advance which asset classes will perform best in the future so, rebalancing keeps your investments diversified.
But even with all the support for rebalancing, there’s also a motive to skip it.
Reasons to Skip Rebalancing
Sam Stovall, in the August 2019 American Association of Individual Investors Journal, wrote on the rebalancing frequency that offers the best risk-adjusted return. He studied seven rebalancing schedules for a 60% stock 40% bond portfolio spanning 1976-2019. Four rebalancing approaches ranged from quarterly rebalancing for the most frequent to rebalancing every four years. Two more approaches rebalanced when the holdings grew beyond either a 5% or 10% threshold. The final approach involved never rebalancing.
The annualized returns for each strategy ranged from a low of 9.98% for the six-months rebalancing schedule to 10.37% for the never rebalancing portfolio. Examined in a different way, $1,000 invested on Dec. 31,1975, grew to $62,214 by mid-2019 with twice-yearly rebalancing and $72,537, with no rebalancing.
So, if you have a really strong stomach, and historical returns prevail, then never rebalancing could yield greater returns than any other schedule.
The analysis also considered standard deviation, which measured the volatility of each rebalancing schedule. The most volatile portfolio, with no rebalancing had an annual standard deviation of 13.07% with an average bear market loss of 22.7%.
Another way to look at the risk vs. return of various rebalancing schedules is the return-for-risk ratio. Measured statistically, the return-for-risk ratio divides the return by the volatility and shows the amount of return that was received for each $1 of risk taken. The no rebalancing portfolio garnered the lowest return-for-risk ratio of 0.79. While the greatest return-for-risk portfolios of 0.94 were these portfolios: quarterly rebalancing with an average annual return of 10.07% and the annual end-of-year rebalancing with a 10.05% return.
So, although the no rebalancing portfolio earned the highest annualized returns, this portfolio also experienced outsized volatility.
How Much is an Extra 0.37% Annual Return Worth?
If these numbers hold true, for an initial investment of $10,000, after 43 years, you’ll earn roughly an extra ($72,500-$64,000) $8,500, or $200 per year, if you never rebalance, in contrast with the average amount earned from all other rebalancing schedules. But, in exchange for the extra cash, you’ll own an investment portfolio that’s approximately 23% more volatile than the annual or semi-annual rebalanced portfolio.
Interestingly, all of the choices delivered a return-for-risk ratio between 0.93 and 0.94 except the never rebalancing ratio of 0.79.
So, if you are willing to withstand the risk, then you may be able to eke out a higher return by never rebalancing. Otherwise, choose any rebalance schedule that you prefer, and you’ll enjoy an excellent return-for risk ratio.
Barbara A. Friedberg, MBA, MS is a veteran portfolio manager, expert investor, and former university finance instructor. She is editor/author of Personal Finance; An Encyclopedia of Modern Money Management and two additional money books. Also, she is CEO of Robo-Advisor Pros.com, a robo-advisor review and information website. Additionally, Friedberg is publisher of the well-regarded investment website Barbara Friedberg Personal Finance.com. Follow her on twitter @barbfriedberg and @roboadvisorpros. As of this writing, she does not hold a position in any of the aforementioned securities.
