Last week, I quickly touched what rebalancing is and what methods of rebalancing are out there. In addition, I checked a time-based method for a traditional 60% stocks and 40% bonds portfolio. As a quick refresher, the time-based method assumes rebalancing on a periodic schedule, for instance, on a monthly, quarterly, semi-annual, or annual basis. You can do it even daily, if you want to. It all depends on your preferences.
According to my testing results, rebalancing indeed adds value. It reduces the portfolio risk (main purpose), but also slightly enhances portfolio performance, which I take as a bonus for all the hustle doing it. However, in order to see the benefit, you need to wait at least a couple of years. I know nobody likes to wait, but this is how investing works – it is a long-term process. Well, it may be a mid-term as well, but in this case, it usually depends on your timing and luck, to some extent.
Even though, annual rebalancing showed best results, there is no one-size-fits-all solution. During trend markets, you want to rebalance less often and ride the uptrend for as long as you can or avoid buying into the falling market. However, during choppy and volatile markets more frequent rebalancing works better, because chances to catch a bottom or sell on top are higher.
One final thing. The frequency of the time-based rebalancing doesn’t depend on the proportion of stocks and bonds in your portfolio. I have tested an aggressive 80% stocks and 20% bonds portfolio and a conservative one with 40% stocks and 60% bonds. In both cases, annual rebalancing performed better.
In this post, I would like to quickly check if adding additional asset classes to portfolio affects the frequency of the time-based method.
Here are my assumptions:
- Testing period: 12/31/2003 – 3/20/2015
- ETFs used: “VTI” for US stocks, “AGG” for bonds, EFA for developed markets stocks, EEM for emerging markets stocks, IYR for real estate and GLD for gold
- Rebalancing frequency: quarterly, semi-annually, annually, and no rebalancing
- Starting portfolio balance $100,000
- Trading transactions and taxes are not accounted for
In order to see the effect of multiple asset classes in the portfolio, I created a sample diversified portfolio of 6 asset classes (similar to Lestna 70 portfolio offered by my firm):
- US Stocks – 35%
- Bonds – 20%
- International developed markets stocks– 15%
- Emerging markets stocks – 10%
- Real Estate – 10%
- Gold – 10%
As you can see in the charts below, rebalancing annually again performs better than any other frequency, not matter how many asset classes in the portfolio. However, one important note: depending on each class proportion in the portfolio, the frequency of rebalancing may be affected as well. For example, in my testing I noticed, that a high portion of real estate in the portfolio makes quarterly rebalancing a more preferred way than annual.
What draw my attention here is that the more asset classes we have in the portfolio, the higher the benefit of the rebalancing. In the zoomed version of the chart, it can be seen that “no rebalancing” portfolio with multiple asset classes lags by a higher margin from an “annually rebalancing” portfolio when compared to a traditional 60/40 portfolio.
Finally, before I close the time-based rebalancing topic let’s look at the numbers:
By all measures, annual rebalancing significantly decreased risk as measured by standard deviation (13% versus 13.9%) and as a bonus rewarded investor with an additional 1.6% per annum (21.2% compound annual growth versus 19.6%).
- Time-based rebalancing in a time-consuming, but pretty easy and intuitive method to reduce the level of portfolio volatility and enhance the performance.
- In general, no matter how many asset classes are in your portfolio, annual rebalancing performs better than quarterly or semi-annual frequency. However, depending on the weight of a specific class, it may be happen that more frequent rebalancing works better.
- The more asset classes in your portfolio (the more diversified it is), the higher the benefit of rebalancing is.
- Annual rebalancing should probably be taken as the basis for the time-based rebalancing, especially for individual investors.
Next time, I will analyze the threshold method of rebalancing and summarize which method is the best in accordance with my testing.
Thanks for reading.