When To Rebalance Your Portfolio

Published in Investing Strategy on 19 October 2009

If you're following a simple asset allocation strategy, when should you tweak your portfolio?

My last article on asset allocation looked at constructing a portfolio mix with which the investor was comfortable, and which had the possibility of delivering a decent return.

Not straying too far from conventional wisdom we settled on a portfolio weighting of 60% equities (and 'other assets') and 40% bonds. The big question then becomes; what the heck do you do now? Or rather, what do you do over the next 20 years (or whatever) as the individual assets rise and fall with various market cycles. 

When buy and hold works best

Buy and hold can be seen as the default option for the idle investor. In a simple 60% equity (and 'other assets'), 40% bonds it would mean reinvesting dividends in the equity portfolio and coupon income in the bond portfolio.

But buy and hold isn't just a default option. Depending on your outlook and risk tolerance buy and hold may be a perfectly rational strategy.

In a long-term equity bull market such as the 1990s, buy and hold very effectively captures all the upside of equity exposure. The problem is that by definition and construction the portfolio becomes higher risk. After a few years, the original 60/40 mix could become 90/10, leaving the investor exposed to a bear market, as of course occurred in the early noughties.

But there are very few periods that that can be described as long trending. Most of the time markets oscillate. And in an oscillating market the buy and hold strategy never mops up more equities at bargain prices (except by default when reinvesting dividends).

The constant mix strategy

As you can imagine, this strategy remains true to the original intention; to maintain a balanced portfolio over time. 

If the desired asset allocation is 60% equity, 40% bond, then when equities or bonds deviated from this weighting they would be sold, or bought, until the status quo was restored.

It also has the intuitively attractive feature of being contrarian. You are effectively being 'forced' to sell your overpriced assets (which become over weighted) and buy into underperforming assets. As such it will outperform in an oscillating market where the underlying trend is up.

As an interesting aside, the constant mix strategy does expose a major assumption of asset allocation --  while different assets move in different directions over the short term, they trend up over the long term. The Japanese investor who annually sold his high-flying government bonds to rebalance his Japanese equities would not be enjoying a happy retirement right now.

Two unanswered questions

The constant mix strategy does raise two important questions which, despite some robust research, have not been conclusively answered:

1. With what frequency should the asset mix be reviewed?

2. What percentage deviation from initial allocation triggers a rebalance?

Clearly rebalancing too frequently will increase transaction and trading costs and possibly have taxation implications. Similarly, rebalancing with only minor deviations from the initial allocation will never allow the 'running of winners' that has been proven to generate good investment returns.

To answer some of these questions we have to turn to the work of practitioners and the conclusions are mixed.

A 2006 research paper published in the Journal of Financial Planning concluded that, while reallocating assets was useful, no single approach was superior. 

A Morningstar study of over 80 years of data showed rebalancing a 70% equity/30% bond portfolio monthly gave an annual return of 9.3%. Never rebalancing returned 10%. 

Other research indicates the optimum rebalancing period to be between 39 and 44 months.

What about my views? Well, based on my 29 years of active investment, my big learning point has been that you want to capture the big moves, and you want to do so over a sensible time period. 

My preference is therefore to review my portfolio annually and rebalance if any asset is more than a quarter away from its target weighting. So if I was aiming for a 60% equity/40% bond portfolio, when the equity proportion became 75%, I'd want to capture that gain and 'bank' it.

More from Tudor Davies on asset allocation:

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gordonbanks42 20 Oct 2009 , 2:07pm

When you backtested the "permanent" portfolio (of which you have written a couple of times recently), did this include any rebalancing? I would assume not, since none was mentioned.

What would the returns have been if you had?

It doesn't surprise me that rebalancing can destroy value when applied to a straight equity/bond mix. As you say, the greatest benefit of rebalancing is using the excess returns of one asset class to buy another on the cheap, but foregoing further increases in equities in order to pick up cheap bonds is unlikely to pay much of the time because the peaks and troughs of the bond market aren't nearly as big as those of the equity market. The best you can hope for is to use bonds as a store of value during equity slumps, but that's not too sure a bet either.

The holy grail is to find a few negatively correlated asset classes with similar levels of volatility. And high trend growth rates into the bargain, if you can manage it! (and some left-handed unicorns, please, while you're at it)

A slight quibble - rebalancing does not require long-term upward trending in order to add value. It is quite easy to show that rebalancing between two negatively correlated asset classes which both have a zero growth trend can create positive returns, if there is enough volatility and the rebalancing frequency is right. The key is that, as in your Japanese equity example, none of the asset classes used has a (significant) downward trend in the long term.

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