It Doesn’t Matter How You Rebalance, Just That You Do | Personal-finance

(Adam Levy)

Periodically rebalancing your portfolio is a necessary task for investors. Rebalancing a portfolio is the act of selling some assets and buying others in order to maintain a target asset allocation. Maintaining your asset allocation will reduce volatility, providing more predictable returns. That way you can ensure you’re money’s there when you need it.

There are a few ways to decide when and how to rebalance. You can do it on regular intervals, most commonly every year. Or you may wait until your allocations reach upper or lower bounds, theoretically producing more opportunistic times to buy and sell various asset classes.

After analyzing over 150 years of market returns, the results for both methods are nearly identical. But the impact of neglecting to rebalance is quite noticeable.

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The model portfolios

For this analysis, I used a 60/40 ratio of stocks to Treasury bonds.

I used a bounded rebalance strategy that pushed the portfolio back to 60/40 whenever bonds grew to 48% or shrunk to 32% of the portfolio value. I checked this portfolio every month for rebalance opportunities.

I compared the bounded rebalance strategy to an annual rebalance strategy that would rebalance every 12 months. I further compared both to a strategy of starting with a 60/40 asset allocation and never rebalancing.

I generated portfolio returns for 40-year periods starting with January 1871 and ending with March 1982.

Which method produces better returns?

If you want to maximize your portfolio returns over the long run, you may as well invest 100% in stocks. Few other passive investments consistently produce better real returns over time.

As such, I figured the bounded rebalance strategy would produce better returns than the annual rebalance strategy. The bounded strategy would let stocks make multi-year gains before selling some to rebalance. Perhaps, however, a 20% bound on bonds is too tight, because the annual returns were nearly identical.

Data source: Robert Shiller, author. Calculations by author. Chart by author.

As you can see, the minimum, maximum, and mid-range (25th to 75th percentile) returns for both rebalancing strategies were separated by mere base points. It made no difference which method was used to rebalance.

On the other hand, not rebalancing for 40 years usually allowed stocks to run higher and produce returns about one-quarter of a percentage point higher on average than rebalancing. But the range of returns was also significantly higher. (See how much wider the middle 50% of results are.)

Again, if all you wanted were the highest expected returns over any given 40-year period, investing all your money in stocks would produce the best results. But proper asset allocation is about producing more consistent returns from year to year, so your money is there when you need it.

Which method produces more stable returns?

While investing 100% in stocks would produce better returns on average, the volatility in an all-stock portfolio may be untenable for many. Most retirees probably couldn’t easily stomach a 40% drop in their portfolio value when they’re relying on it for their income.

The main point of rebalancing your portfolio is to reduce volatility throughout your investment lifetime. Investors looking for more stable returns will want to keep a higher percentage of their portfolio in bonds. Additionally, maintaining a balance of stocks and bonds can produce maximum risk-adjusted returns by investing on the efficient frontier.

To that end, the impact of either rebalancing strategy is a significant reduction in volatility over no rebalancing.

Data source: Robert Shiller, author. Calculation by author. Chart by author.

The difference in volatility between annual rebalancing and bounded rebalancing strategies is minimal. The median standard deviation for annual returns over each 40-year period is separated by just one-tenth of a percentage point.

By comparison, the volatility of the unbalanced portfolio is far higher than both. The median standard deviation of the annual portfolio balance of 13.84% was far higher than either rebalanced portfolios, which landed around 11.5%.

Furthermore, the median maximum drawdown over a 40-year period for the rebalanced portfolios was around 25%. The unbalanced portfolio saw drawdowns of 37% or more half the time. The maximum drawdown for the unbalanced portfolio was 77.05% for the investor who started in August 1896 (coinciding with the great depression). Both rebalanced portfolios managed to keep the drawdowns to a maximum of around 60% for the same period.

Which method should you use?

The method you use is up to personal preferences.

If you want simplicity, rebalancing annually means you only have to check in on your portfolio once a year and make a few transactions.

If you want to make fewer transactions, you can go years without rebalancing if you use a bounded approach. The bounded approach is also more customizable.

There may be tax considerations to take into account. Perhaps it’s beneficial for you to rebalance in December every year, locking in gains on some assets little by little. Perhaps you’d like to defer taxes as much as possible by only rebalancing when absolutely necessary.

If you’re in the accumulation or decumulation phase of investing (which probably describes most investors), you may simply rebalance as you add funds to your portfolio or sell assets to fund your lifestyle. That should keep you close to your target allocation at all times.

Maintaining your target asset allocation is essential to producing more stable portfolio balances. While keeping a balance of bonds alongside stocks will sacrifice some expected return, the diversification they provide protects your portfolio from the wild swings of the stock market. When it comes down to it, it does not matter how you rebalance – just that you do.

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