Periodic rebalancing of a portfolio is an important method for maintaining proper diversification within a portfolio as your assets appreciate over time. Rebalancing will return your portfolio to your predetermined asset class allocations. This allows the investor to control the relative contribution of each asset class to the overall variance of his portfolio. Without rebalancing, the variance of the portfolio will be skewed towards the highest performing asset class.
Beyond the value in maintaining desired diversification, rebalancing can actually boost portfolio returns. Below we list several of the necessary conditions required for rebalancing to have a positive impact on returns. When other conditions are present, rebalancing can reduce portfolio returns.
Conditions that support increased returns
While rebalancing can often lead to lower standard deviation for your annual returns, there are a set of circumstances where rebalancing will actually boost the performance of a portfolio. These conditions include:
Uncorrelated or negatively correlated assets – Positively correlation among asset classes will render rebalancing less meaningful
Mean reversion properties – When assets behave with a tendency to revert to the mean, then it is more likely that the asset will appreciate at a higher rate than its mean if it has underperformed in the past. Rebalancing serves to move investment dollars into underperforming asset classes. Equities appear to demonstrate mean reversion properties for some periods of time while displaying more trending behavior in other periods.
Similar rates of returns for assets – If one asset class has a significantly higher mean rate of return, then rebalancing can reduce the overall portfolio’s performance. In this case, the rebalancing will move funds away from the fastest growing asset class.
High variances within individual asset classes – High variance leads to the situations where asset classes will (1) substantially outperform the portfolio for periods (during which time the rebalancing will take profits out by selling these shares) and (2) substantially underperform the portfolio in other periods (when the rebalancing will buy shares at the reduced price). The net, long-term result of these swings will be higher return for the overall portfolio.
To test the impact of rebalancing on annual returns and portfolio variance, we have constructed some sample portfolios and used historical data to compare an annual rebalancing policy versus a policy of not rebalancing. These portfolios will be constructed from five asset classes (US Large Cap Stock, International Equities, Emerging Markets Equities, REITs, and US Treasuries). The respective indexes used will: S&P 500, MSCI EAFE, S&P IFC Emerging Markets, S&P REIT and Dow Wilshire REIT and US 5-yr Treasury bonds. Data was collected from Index Fund Advisors and the Global Financial Data website. We will analyze the policies over a 30 year (1975-2004), 20 year (1985-2004) and 10 year (1995-2004) horizon. We’re interested in the differences in annual return (geometric mean) and standard deviation.
Our first portfolio consists of 40% US Large stock, 20% International Equities, 20% Emerging Markets and 20% US Treasuries. Below are the results for the three time periods.