Tuesday, March 6, 2012

Keep the Benefits of Portfolio Rebalancing in Perspective

Many commentators preach the benefits of choosing an asset allocation strategy, sticking with it, and rebalancing regularly. This is good advice, but some investors overestimate the benefits of portfolio rebalancing. If done properly it can certainly increase returns, but the gains are usually quite modest.

Consider the following example. Emily starts with a balanced portfolio worth $22,000, half in a stock ETF and half in a bond ETF. Initially, both ETFs trade for $50. Emily’s starting portfolio looks like this:

Stocks: 220 shares @ $50
Bonds: 220 shares @ $50

Now, suppose the stock ETF goes up 10% and then comes back down again. If Emily does nothing, her final portfolio value will be $22,000, the same as it was at the start. But, if she rebalances, she will make some money. Let’s see how much she can make (ignoring commissions and spreads for now).

After the stock ETF has gone up 10%, Emily’s portfolio looks like this:

Stocks: 220 shares @ $55
Bonds: 220 shares @ $50

To rebalance, Emily sells 10 shares of stock and uses the resulting money to buy 11 shares of bonds. Her portfolio is then balanced again with $11,550 in both stocks and bonds:

Stocks: 210 shares @ $55
Bonds: 231 shares @ $50

Then stocks drop back to $50 and Emily’s portfolio is now

Stocks: 210 shares @ $50
Bonds: 231 shares @ $50

Her total portfolio value is now $22,050. She has made $50 from rebalancing. This is a gain of only 0.23%. She’s happy to take this money, but it’s not a huge gain. And in reality, she will lose most of this to trading commissions and the bid-ask spreads.

The moral here is that rebalancing is useful, but it cannot make up for differences in the expected returns of different asset classes. If you choose to own different asset classes to reduce your portfolio volatility, this can be a sensible choice, but don’t think that rebalancing can make up for big differences in the expected returns from different asset classes.

2 comments:

  1. It's a great point. Rebalancing should mainly be thought of as risk management tool, and any incremental benefit you might get from it is a bonus. I did an analysis of this a while back and found that the benefit over the last 20 years was about 30 basis points, and only if you assume zero costs.

    http://canadiancouchpotato.com/2011/03/07/does-rebalancing-boost-returns/

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  2. @Dan: I find that people are either completely unaware of the slight benefit of rebalancing or they think its benefits are much greater than they really are. I think some people imagine making a big shift when one asset is very low. In reality, rebalancing almost always involves tiny shifts, and most people choose not to rebalance at the very time that it would give the greatest advantage.

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