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A deeper dive into rebalancing your portfolio

I wrote an article on allocating and rebalancing your portfolio around 2 months ago. In this article, I like to take a deeper dive into the rebalancing aspect and explain a bit more on the various aspects of rebalancing your portfolio.

Now firstly, I believe most of us probably briefly understand what rebalancing your portfolio means. Some aspects of your portfolio probably goes out of the norm which you have set, and you decided to take corrective actions to reassign the correct weightage to various components in your portfolio. What is probably not so clear/obvious to most people is that rebalancing does not always necessarily mean increasing your returns. Yes, you heard it right. An unbalanced portfolio could potentially provide you better returns than a rebalanced portfolio. Imagine you have 60% of your portfolio in equities and 40% of your portfolio in bonds, and you happen to be in the middle of a bull market in equities. An unbalanced portfolio would further compound the returns of the equities while a rebalanced portfolio could actually hinder your returns. And hence, the unbalanced portfolio could do better in this case.

Then why do we bother ourselves with rebalancing of our portfolio? If it's not providing me with better returns, shouldn't I just ignore it?

Well, the keyword here is risk. While there is potential to get higher returns via an unbalanced portfolio, you are inevitably exposing yourself to even more risks. From the angle of portfolio management, you are getting a lower sharpe ratio (poorer risk-return) as the amount of risks you are exposed to outweighs the potential returns of your portfolio. Just imagine what if you are not so fortunate to be in the middle of a bull market in equities as highlighted in the previous example. You could potentially be even making losses from the equities if you happened to buy at the peak of the bull market. And you would be thinking if you are better off rebalancing your portfolio from time to time.

To illustrate this, I like to bring forth the example of the All-Weather Portfolio which I was highlighting in a previous article.

Here is the results for the All-Weather Portfolio (without any rebalancing)

(Source: Portfolio Visualizer)

Now, here is the results for the All-Weather Portfolio (with annual rebalancing)

(Source: Portfolio Visualizer)

Notice how the version (with annual rebalancing) ends up performing poorer in terms of CAGR (7.91% as compared to 8.44%)? However, the risk (standard deviation) of the version (with annual rebalancing) is lower (5.61% as compared to 6.1%) and hence the sharpe ratio is slightly better (1.28 as compared to 1.26).

So which type of market do rebalancing of portfolio reaps the most benefits? A study done by Northern Trust in 2018 sheds some light on this. In this study, three different kinds of rebalancing methods are investigated on simple equity/fixed income portfolios in greater detail across a study from September 1995 to December 2017 (which comprises 2 full economic and financial market cycles). The three different kinds of rebalancing methods are namely frequency based, threshold based and risk based. In the case of frequency based rebalancing method, different periods such as monthly, quarterly, semi-annually and annually are looked into. In the case of threshold based rebalancing method, set ranges around asset classes/individual product selection is explored. The last category (risk-based) is similar to what's being explored in the second category (threshold based) with a main focus on the risk levels across the various asset classes/individual product selection.

As this study is done across a long period of time, we are able to explore how these various different kinds of rebalancing methods perform across various types of market conditions (Up Markets, Down Markets and Sideway Markets). Here are the results.

In up markets (where S&P 500 is on an uptrend to a new peak), none of the rebalancing methods performs better than a simple buy and hold method. In down markets (where S&P 500 is on a prolonged drawdown), none of the rebalancing methods performs better than a simple buy and hold method again! At this point of time, you would be thinking why do I still rebalance my portfolio then?

This is where it gets interesting.

When the market is moving sideways with no clear trend, a good number of these rebalancing methods actually outperforms the buy and hold method. And when you look at the full period (September 1995 to December 2017), most rebalancing methods do end up outperforming the buy and hold method in terms of returns, risk and efficiency as they provide the investors with better returns coupled with lesser risks. While the buy and hold method outperform the rebalancing methods in certain segments of an economic/financial market cycle), rebalancing still turns out to be the clear choice in full view of the data.

I personally think this is where the message gets driven home. Nobody is able to perfectly anticipate or conclude if we are going to be in an up market/down market or sideway market. Chances are either of these three can happen in the blink of an eye. Instead of focusing where the market is heading towards, it probably makes more sense to take a really long term perspective in your portfolio and rebalance it as it has been clearly shown from this study that rebalancing your portfolio does beat a simple buy and hold method when you view it from a full economic/financial market cycle. I strongly suggest you read through the study as there are more things investigated or highlighted in the study which I did not go into full details here.

Of course, there are also certain factors/conditions which you should be aware of to improve your returns or risk-adjusted returns when it comes to rebalancing your portfolio. Here are some of them.

Rebalancing your portfolio works well when the rate of returns across the various asset classes in your portfolio are similar. If it doesn't, the shift of funds will be purely one sided with the funds from the investment of the asset class with a high rate of return constantly being channeled into the other asset class of a low rate of return. This would then hinder the growth of your portfolio. Besides that, the various asset classes which you have in your portfolio should be uncorrelated or negatively correlated. Asset classes often move in full cycles with various periods of ups and downs. By investing in asset classes which are uncorrelated or negatively correlated, you could take advantage of channeling your gains from an asset class which is in its up cycle to another asset class which happens to be in its down cycle. In this way, your gains will be further compounded when that particular asset class resumes its upswing later on. And this is also the reason why rebalancing a portfolio also pays off well when the asset classes have huge variances or are volatile in prices as you are constantly taking profits and re-buying them at lower prices.

So, do remember the points highlighted in this article the next time you are looking at rebalancing your portfolio. More importantly, remember to stay balanced.

Till the next time.

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