What is portfolio rebalancing?
Jim Cramer is famous for saying that proper diversification in the only "free lunch" in the world of investing, but he's wrong. There's a second freebie: rebalancing your portfolio.
Per Investopedia, "Rebalancing is the process of realigning the weightings of a portfolio of assets. Rebalancing involves periodically buying or selling assets in a portfolio to maintain an original desired level of asset allocation."
Suppose you have a portfolio with two holdings, each with a target allocation of 50%. It is overwhelmingly likely that these assets will not perform identically (at least in the near-term), meaning that your asset allocation is going to become distorted over time as one of your holdings outperforms the other.
So what do you do? Letting your winners ride is a common sentiment, but the advice is misguided for investors who are in it for the long haul. Since an asset's performance tends to revert to the mean, an outperformer in the short term is likely to underperform at some point in the future to compensate, and vice versa.
This simple observation gives investors who rebalance an inherent advantage. Rebalancing allows them to sell into the relative strength and buy into the relative weakness of their assets without having to actually time the market, giving them a boosted return when the assets' performance reverts to the mean.
The math to prove it
To demonstrate my claim I backtested 20 different hypothetical portfolios, each consisting of five randomly selected companies that have been components of the S&P500 for at least 20 years. Each of the five companies in a given portfolio were given an equal target weighting of 20%. I then found the CAGR of each portfolio between 1997 and 2017 when rebalanced monthly, yearly, and not at all. The different hypothetical portfolios can be found here. Here are the results:
There's a pattern here, but it's not perfect. In general we can see that the portfolios performed better the more often they were rebalanced.
Only five of the twenty portfolios performed best without rebalancing. These portfolios all contain at least one stock where "letting your winners ride" paid off hugely - in other words the stock's performance hasn't reverted to the mean (at least not yet). For example, portfolio #9 contains MasterCard and portfolio #10 contains Apple.
If you still believe that it's a coin toss whether rebalancing is better than not rebalancing, the probability of the rebalanced portfolios outperforming 15 times or more out of 20 is just 2.07%.
Let's delve deeper and look at the average CAGR of the portfolios under the three different conditions. To make things more interesting I'll also show you the standard deviation, which can loosely be interpreted as volatility.
The results are clear: you're favoured to increase your return and reduce your portfolio's volatility the more often you rebalance.
This makes some intuitive sense:
- Increased average return: by rebalancing you sell your holdings in times of strength and increase your holdings in times of weakness, allowing you to take advantage of the fact that an asset's performance is likely to return to the mean in the long run.
- Reduced volatility: by keeping your portfolio balanced you remain properly diversified, which reduces volatility.
Not rebalancing has the potential for higher returns by giving you a chance at picking the next Apple and letting it ride (see the outperformance of portfolio #10 above), but generally you're at a statistical disadvantage compared to someone who does rebalance with the same portfolio.
This little experiment should shed some light on the importance of rebalancing, but there are some important disclaimers:
- There is a significant source of bias in the companies I picked because none of them have gone bankrupt. In reality you'd expect a handful of 100 randomly selected S&P500 companies to fail over this long of a time horizon. The fact that companies can go bankrupt is an advantage for a portfolio that does not rebalance, as money isn't wasted buying stock all the way down.
- The experiment doesn't lead to any conclusions about how often you should rebalance, it simply shows that rebalancing is advantageous in general. This is complicated by the fact that in real life there are transaction fees.
- Rebalancing is only a consideration after you have chosen an appropriate portfolio for your risk tolerance and time horizon. It doesn't give any insight into what you should invest in.
The bottom line on rebalancing
Rebalancing your portfolio regularly can provide increased returns and reduced volatility in the long run by exploiting natural market fluctuations. Keep yourself accountable to your target asset allocation and enjoy the benefits of one of the few "free lunches" in the world of investing.