Thursday, August 11, 2011

Rebalancing Gives No Instant Gratification

Part of the theory behind maintaining a fixed percentage allocation of your portfolio to different asset classes, like stocks and bonds, is that when markets are volatile, you can increase returns by rebalancing.  Unfortunately, there is no immediate return from rebalancing.

To show that rebalancing has created a profit, you need to take into account not just your most recent rebalancing trade, but also the last time you rebalanced in the other direction.  If you do the calculation, it will show whether the second to last rebalancing trade produced a profit, but the most recent one won't show a profit until the next time you rebalance in the other direction.

This situation creates a problem of a delay from effort to reward.  We're much better at doing things that give immediate gratification. 



5 comments:

  1. You have just given me a brilliant idea for my future investor coaching service: rebalance and get a cookie.

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  2. Anyone who believes in re-balancing, must do it.

    Being too cautious defeats the purpose. Timing your trades is counter to the basic idea of re-balancing.

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  3. Well, rebalancing is not about boosting returns. It's about managing risk. Maybe you can get a warm fuzzy from seeing that your asset allocation has protected you from recent stock market volatility, and you can feel good about restoring your carefully-chosen asset allocation by rebalancing?

    Ok, I'm grasping at straws here. I think rebalancing is inherently an unemotional activity.

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  4. @Potato: Great idea. Can I have a steak instead?

    @Mark: Agreed. Unfortunately, many investors who have a plan that involves rebalancing don't do it during volatile periods for stocks.

    @Patrick: I agree that rebalancing is primarily for limiting risk. However, it does have the side benefit of a boost to returns during volatile periods where asset classes don't have high correlation. Too few investors are able to bring themselves to restore their percentage allocation to stocks when stock prices fall. They tend to sit tight and wait for things to calm down, or worse, sell stocks when they're down.

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