You have probably heard a term “rebalancing” multiple times. Financial pundits and investment experts continue to pinpoint that this is one of the key elements of successful investment process. There is little to argue with and you will see soon why you should do it.
Before I run the numbers, let’s briefly define what rebalancing is and what methods of rebalancing exist.
What is Rebalancing?
Rebalancing is the process of getting the weightings of asset classes in the portfolio back to their target weights. The main purpose of the rebalancing is not to increase the returns, but to decrease the risk of your portfolio. Over time, the weight of each asset class in the portfolio will deviate from its target weight mainly due to market fluctuations, new contributions/withdrawals from the account, and periodically received income, like dividends or interest. To illustrate that, say you invested 50% in stocks and 50% in bonds. Some time later, your allocation structure may change to 70/30, 30/70, or any other proportion, which no longer represents your target 50/50 allocation. What do you do about it? You need to rebalance. Simply stated, you sell the overperforming asset class (or fund/stock) and buy underperforming. For instance, if your stocks proportion increases to 70% you sell 20% of stocks and buy 20% of bonds, realigning current weights back to their target. Though it may seem counterintuitive buying low and selling high, this is exactly the right approach you need to take.
Depending on your preferences, you can rebalance your portfolio by utilizing one of three methods:
- Predetermined threshold.
- Combination of both methods.
Periodic time-based: you do your rebalancing either monthly, quarterly, semi-annually or annually. You can even do it daily or constantly if you prefer to.
Predetermined threshold: you rebalance the portfolio when your allocation weights deviate by N%, for example, 1%, 3%, or 5%.
Combination: you rebalance your portfolio at the end of a chosen period, but only when your weight deviates by more than a predetermined level. For example, you rebalance your portfolio every quarter, but only when the weight has deviated by 5% or more.
How Often to Rebalance?
Now, that we have defined what rebalancing is, its purpose and methods, let’s get to the numbers and see how frequently to rebalance. In this post, we will take a look at the periodic time-based rebalancing method for a traditional 60% stocks and 40% bonds portfolio. In addition, I decided to compare it with aggressive 80%/20% and conservative 40%/60% portfolios. Here are my settings:
- Testing period: 12/31/2003 – 3/20/2015
- “VTI” ETF as a proxy for stocks and “AGG” ETF for bonds
- Rebalancing frequency: quarterly, semi-annually, annually and no rebalancing
- Starting portfolio balance $100,000
- Trading transactions and taxes are not accounted for
Initially, let’s see if one should bother with rebalancing at all.
Since the chart is too big, I zoomed in the area starting 2014.
According to the charts above, we can see that rebalancing definitely makes sense. Yearly rebalancing works best followed by semi-annually and quarterly. “No rebalancing” portfolio is the worst performer.
However, it is not very clear by how much each rebalancing frequency outperforms/lags the other. More importantly, does the rebalancing decreases the risk of the portfolio?
Let’s analyze year-by-year breakdown below.
As can be seen, annual rebalancing benefits the investor the most, both in terms of risk and reward. Over the testing period, the portfolio value increased to $226,413, which is 3.67% more than “No rebalancing” portfolio, with a compound annual growth rate of 19.5% vs. 18.8%. But what is more importantly, portfolio risk, as measured by standard deviation, is lower than “no rebalancing” portfolio, meaning that rebalancing does its main function – decreases the level of portfolio volatility.
What is interested here is that quarterly rebalancing didn’t perform as well as most experts say it should. Its risk is higher and return is lower when compared to semi-annual and annual rebalancing strategies. However, even quarterly rebalancing improves portfolio performance and reduces risk.
Before I compare 60/40 portfolio with 80/20 and 40/60 to see if annual rebalancing still performs better than quarterly or semi-annual, allow me to quickly run through the spread section of the table. The spread section (chosen frequency return – no rebalancing return) shows the CAGR spread and average spread for each frequency. On an annualized basis, annual rebalancing spread is 0.7% (the highest among other frequencies), meaning that annual rebalancing strategy annualized return is 0.7% higher than “no rebalancing” portfolio’s. Average spread is again higher for annual rebalancing, which is 0.3% and assumes that on average, annual rebalancing is expected to provide an advantage of 0.3% over “no rebalancing” portfolio.
If you look at the right section of the table, you will notice that during some years quarterly rebalancing works best (marked green), sometimes semi-annual or annually are doing better. Here are the conclusions I’ve come to:
- During choppy and volatile markets, quarterly rebalancing works better. The obvious reason here is that there is a higher chance to “catch” bottoms and sell at tops.
- During trend market, no matter whether it is an up or downtrend, annual rebalancing performs better. You are better off to ride the trend for as long as it lasts. If it is an uptrend you will not be forced to sell into rising market and, hence, reduce exposure to an outperforming portion of the portfolio. During bear markets, you will not be forced to buy deeps and seeing how the market continues to move further down, dragging the portfolio with it.
- Rebalancing heavily depends on market timing abilities. If your timing is off, you might miss a big price move. However, market timing is not possible thing to do, so the best option is simply to create a rebalancing plan and rigorously follow it.
80/20 and 40/60 vs. 60/40
One more thing I would like to check is to see if there is a difference in the time frequency of rebalancing for aggressive 80/20 portfolio and for more conservative 40/60 portfolio, where 40% is invested in stocks and 60% in bonds.
As we can see below, annual rebalancing is still the way to go, no matter what is the proportion of stocks and bonds in your portfolio.
- Rebalancing definitely works! It improves the performance and, more importantly, decreases the risk.
- It takes some time in order to start seeing the benefits of rebalancing, usually 3-4 years.
- There is no one-size-fits-all solution. Generally, less frequent rebalancing provides better results. However, rebalancing frequency significantly depends on both market timing abilities and market trendiness.
- During volatile and sideway markets more frequent rebalancing works better. During trend market, no matter what direction of the trend is, you are better off by rebalancing less frequently.
- Rebalancing does not depend on the proportion of stocks or bonds in your portfolio. It adds value whether you have an aggressive or too conservative portfolio.
Can You Do Rebalancing on Your Own?
As you can see, time-based rebalancing requires a disciplined approach. You need to choose your preferred frequency and then stick to it. Besides that, you need to take into account transaction costs, taxes (if applicable) and it may be very time-consuming. Despite all that, you absolutely can do rebalancing on your own and, probably, the best approach for individual investors is to do it annually.
You may wonder what method I prefer? Depending on multiple factors, I have found that “combo” is the best approach for my clients and me. However, I do it with one modification. Instead of waiting for the end of each period, I can rebalance the portfolio when the proportion of each asset class or individual stock(s) exceeds a predetermined threshold at any time, not only at the end of specific interval, which is usually semi-annually.
Next week I will look if adding additional asset classes to the portfolio have any effects on the frequency of rebalancing and check the second method: rebalancing at a predetermined threshold level.