Why it’s important to rebalance your portfolio

What is rebalancing your portfolio?

A common saying among investors is that the only ‘free lunch’ out there is proper diversification – but they’re wrong. There’s a second freebie: rebalancing your portfolio.

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.

Investopedia

Suppose you have a portfolio with two holdings, each with a target allocation of 50%. It is likely that they will not generate the same returns over time, meaning that your asset allocation is going to become distorted as one of your holdings outperforms the other. You may check back in a year and find that one of your holdings now makes up 60% of your portfolio.

So what do you do? Letting your winners ride is a common approach, but this is not the best strategy 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 fact gives investors who rebalance their portfolio an inherent advantage. Rebalancing allows them to sell when times are good and buy when times are bad, without having to actually time the market. In the long run, this boosts returns and reduces volatility.

Proof that rebalancing your portfolio increases returns and reduces volatility

To demonstrate the benefits of rebalancing, I backtested twenty different hypothetical portfolios, each consisting of five companies randomly selected from the S&P 500.

Each of the companies in a given portfolio were given a target allocation of 20%. I then calculated the CAGR of each portfolio between 1997 and 2017 when rebalanced monthly, yearly, and not at all. The different portfolios can be found here

Here are the results:

In general, the different portfolios performed better the more often they were rebalanced. Only 25% of the portfolios performed better without rebalancing.

Let’s delve deeper and look at the average CAGR under the three different conditions. To make things more interesting, I’ll also show you the standard deviation, which is a measure of volatility.

 CAGR and standard deviation under three different conditions.

The results are clear: average returns increase and volatility decreases as rebalancing becomes more frequent.

Limitations of this example

This example should shed some light on the importance of rebalancing, but there are some important things to consider:

  • 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 companies to fail over a twenty year time horizon. The fact that companies can go bankrupt is an advantage for a portfolio that does not rebalance, as capital isn’t wasted buying stock all the way down.
  • This example 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.

Summary

On average, rebalancing your portfolio regularly provides increased returns and reduced volatility. Keep yourself accountable to your target asset allocation and reap the benefits!

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