Updated Monday, June 29, 2015 as of 11:30 PM ET

Portfolio Rebalancing: Get It Right

What is the best thing you can do to improve your clients’ portfolio performance? For a long time, the accepted answer was simple: asset allocation. Now, however, it appears that there is a second factor that might just be more important: consistency in that asset allocation, as maintained by steady rebalancing.

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Comments (8)
Allan, Nice article and incredibly simple to implement if one chooses such a course! I see much of your other work here too. I can tell you are incredibly well respected by your peers. Keep up the great work and thank you!
Posted by Bruce B | Monday, June 02 2014 at 1:34PM ET
We published an article "Let it Ride" in this magazine (Dec.8, 1988) where we studied and established the results of quarterly rebalancing over the period of Dec. 1968 to Dec. 1987. We chose 3 month treasuries, high grade long term corporate bonds, gold, Dow Utility, Dow Industrial, Dow Transportation indexes. The non-rebalanced portfolio slightly beat the rebalanced one, but surprisingly, with less volatility.

At that time we were about to market a pension investing process to businesses, and thought that the idea of methodical rebalancing would endear us to that market and give us a competitive edge. Of course we were surprised (and disappointed) at the results of out study.

I believe that managing portfolios requires a lot more than just blindly rebalancing, which sort of flies in the face of that other parcel of investment wisdom dictating that you should cut your losses and let your winners run.

Of course, financial planners would rather keep it simple, buy some number of inexpensive index funds or etf's and distinguish themselves as more valuable from their competition by promoting the idea of rebalancing on some fixed schedule. This will remain true until "rebalancing" becomes the can't do without criteria for investment management, and than maybe someone will come forth with this study or a newer one, finally shattering the hook so many investment advisors have hung their hats on.

Bill Kaufman (Money Watch Consultants Inc.)
Posted by william k | Tuesday, June 03 2014 at 10:20AM ET
Interesting article. However, we should be careful not to draw general conclusions from one 15-year time period and one that included 2 significant recessions. If the authors were to perform an empirical analysis incorporating a large number of historical time periods, including longer ones, the conclusions would likely demonstrate that rebalancing, especially as frequently as annually, is suboptimal assuming the goal is to maximize portfolio value. The reason is that rebalancing is essentially locking in a static asset allocation by selling better performing investments to buy more of the poorer performing investments.
Posted by Eric S | Tuesday, June 03 2014 at 12:07PM ET
In thinking through the results that we found, I have come back to the idea that rebalancing misses long term trends in financial markets. As a consequence, rebalancing forces continual buy ins to asset classes that could be going through long term down trends or cycles (think long term bonds purchased over rebalancing intervals of years' long rising interest rates, ugh. Or conversely, bonds sold off to rebalance during long periods of decreasing interest rates.

Moreover, for rebalancing to make sense, one has to choose "asset classes" to work with. Ideally these are chosen based on correlation histories.

No one would choose multiple asset classes for a portfolio that were wholly correlated (what would be the point?). But the truth is that asset class correlations change. For example, an asset class can be inversely correlated with another asset class until it's not inversely correlated. Correlations themselves can change. They can be arbitrary and/or temporary.

So we concluded that rebalancing over simplifies the portfolio management process. It survives because it is a "good story" to tell naive prospects, enabling many investment advisors to sell their wares.
Posted by william k | Tuesday, June 03 2014 at 12:23PM ET
It is unfortunate that you continue to propagate the wrong conclusion, so skilfully exploited by the mutual fund industry and other purveyors of retail investments, as a marketing tool, that the "notable research paper" you referred to showed that asset allocation was the single most important determinant of portfolio returns. It did not and it never claimed to do so. What the authors of that paper argued was that it explained about 94% of the portfolio's behaviour; the ups and downs of the portfolio. In fact, the same authors wrote a subsequent paper in which they argued that asset allocation only explained, if memory serves me right, about 40% of the portfolio's performance.
Posted by Victor M | Tuesday, June 03 2014 at 3:06PM ET
This article and the earlier comments seem to buy into "the goal is to maximize portfolio value." That is not the goal of a 'real portfolio'. The purpose of a real portfolio is to meet identified financial goals with high confidence and low enough volatility so that the client can be convinced to maintain the portfolio. Thus, the question is not whether rebalancing increases return, the question is does it achieve a required level of return with less volatility than the non-rebalancing alternative(s) and/or with greater certainty. This article does not answer that, although I find it very interesting.
Posted by Vernon C | Tuesday, June 03 2014 at 3:40PM ET
Good point. It doesn't answer that because in many periods rebalancing doesn't reduce volatility, but actually increases it.

And the performance of a rebalanced strategy is itself very dependant on the chosen asset classes.

For example, suppose you choose to include long term treasuries to include in your portfolio, and during a long period of rising interest rates kept buying more and more, your portfolio would certainly display greater volatility than keeping the original allocation in long term treasuries constant, (thereby diminishing the effect of the losses ((as the treasuries occupy a smaller and smaller portion of the portfolio)).
Posted by WILLIAM K | Thursday, June 05 2014 at 11:49AM ET
My Name is Michael Chindamo. I am the co-founder of Fautores Family Offices. I often wonder what the next grand strategy will be. Strategies described in the article are all about enabling advisors to attract assets under management from the masses.
Investing in general should be all about preservation of one's purchasing power. Preservation of one's purchasing power takes into consideration all of a client's assets and expenses. Wise investors diversify their holdings into many viable assets. It is most important to consider directly owned real estate, art, collections etc., no matter what level. For instance, many years ago my wife and I purchased some antiques for a few hundred dollars each. In today's market they are worth many thousands. I learned the lesson many years ago from an extremely wealthy entrepreneur about the benefits of diversification and the importance of buyng businesses vs. indexes and ETF's. It's all about buying quality at value prices (Warren Buffet) and holding high quality investments for an appropriate time that is suitable to an investors life style.
Often, the assets may find there way to their heirs.
The next point is the importance of purchasing goods at wholesale pricing. Take for ex. Costco. Great business model. They have 4,000 items on the shelf that are higher quality vs. Sam's club's 20,000 lower quality items. Costco offers more quality at less prices rather than low quality for cheap prices (Sam's Club).
We believe that buying high quality goods and services at a bargain (value) equates to preservation of ones purchasing power. This could equate to buying the house next door for cash during a depressed cycle and renting it. You control the asset, you purcahsed it at a discount and have in essence created a bond with an inflation hedge.
That said, you might be able to achieve some of this strategy with stock market investing if you apply the value principles and be prepared to do your homework.
The US is moving in a direction where manufacturing, energy and technologies are taking great hold. There are lot's of opportunities.
I would suggest that the masses look for professional and well credentialed advisors that operate under a fiducary format. Then I would engage them in conversations that relate to one's long-term financial planning, asset protection, estate planning , tax scenarios, family values
and educating their heirs. Once an advisor can aid in all of the alignment, then construct an appropriate asset allocation model that takes into account assets that are invested in the market as well as outside investments.
The typical chase for AUM is a disservice to all investors. Comprehensive financial planning, behavior management, and long-term investing will result in better outcomes.
Posted by Michael C | Saturday, June 07 2014 at 8:48AM ET
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