Does Rebalancing Impact Returns?

New Year: Should You Rebalance Your Portfolio?

The question of when, why and how you should rebalance your portfolio gets attention from the media on a cyclical basis, and despite all of the column-inches devoted to the subject and nudges from fund companies, the conclusions are often the same–sell your winners and buy your losers at least once a year if not once a quarter. This discussion may seem particularly relevant now after all of the volatilityA measure of how large the changes in an asset’s price are. The more volatile an asset, the more likely that its price will experience sharp rises and steep drops over time. The more volatile an asset is, the riskier it is to invest in. we’ve seen in the markets over the last few years, which has pushed many portfolios far from their original allocations.

However, when we look at the data, we have to wonder if rebalancing is necessary that often, if at all, even during times of increased market volatility.

Proponents of rebalancing will tell you that the strategy is all about riskThe probability that an investment will decline in value in the short term, along with the magnitude of that decline. Stocks are often considered riskier than bonds because they have a higher probability of losing money, and they tend to lose more than bonds when they do decline. control–by sticking to a target allocation between stocksA financial instrument giving the holder a proportion of the ownership and earnings of a company. and bondsA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates., growth and value, domestic and international, small-cap and large-cap, and so forth, you can effectively manage the overall risk of your portfolio through various market cycles. To use the standard example, if you had a 60%-40% mix of equityThe amount of money that would be returned to shareholders if a company’s assets were sold off and all its debt repaid. and bondA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates. funds in a portfolio, after a period of stockA financial instrument giving the holder a proportion of the ownership and earnings of a company. outperformance your portfolio could become skewed to a 65%-35% or 70%-30% mix, putting you at increased risk if stocks begin to decline. The theory behind rebalancing is to keep those allocations in check, thus reducing risk. And on the face of it, it’s good advice–but only superficially.

Vanguard and Fidelity have addressed the subject of rebalancing a number of times over the last few years, with the firms recommending rebalancing on a semiannual or annual basis, or when allocations drift more than 5% or 10% away from their targets.

Those conclusions seemed a bit simplistic to us, but before making any judgments we wanted to look at a few numbers for ourselves. We constructed a hypothetical portfolio of Vanguard funds with a 60%-35%-5% split between equitiesThe amount of money that would be returned to shareholders if a company’s assets were sold off and all its debt repaid., bonds and cash (50% to 500 Index, 10% to Total International Index, 35% to Total BondA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates. Market Index and 5% to Prime Money Market) and tracked the results of several rebalancing scenarios from January 1987 (a few months after 500 Index’s inception) through December 2010. (Note: For the period prior to Total International Index’s April 1986 inception we used returns data for the MSCI EAFE Index.)

In the first scenario we rebalanced the portfolio every six months–in January and July. In our second test we rebalanced once a year in January, in the third we rebalanced every third January, and of course we compared these results to a scenario involving no rebalancing at all. (We picked January to rebalance because it’s best to do it after December distributions and after the tax-year has turned.)

The table above is a summary of the rolling returns for each scenario, showing average returns as well as best and worst returns for one-month, one-year, three-year and five-year periods. The table is pretty conclusive: the fewer times you rebalance, the greater the return potential and greater the volatility. When we’ve run these scenarios in years past, the portfolio that was never rebalanced came out as the clear winner over all periods in terms of average performance. After the volatility we experienced in 2008 and 2009 (and despite the subsequent return towards normalcy in 2010), however, the portfolio rebalanced every year moved up to top the leader board. It’s worth noting that no matter which period you look at, the average returns in each scenario are all very similar, with no more than 18 basis points separating any two of them. But you can see much wider swings when comparing the best and worst periods.

So from a volatility standpoint, rebalancing does appear to have a positive effect on a portfolio–you won’t hit the same heights, but neither will you experience the same losses an untended portfolio experiences. A portfolio that is frequently rebalanced also stays much closer to its targeted allocation, but can still be affected by periods of high market volatility, as was the case in 2008 and 2009 and even the last few months of 2010, a year in which overall stock market volatility declined from previous years. Through year-end 2010, the portfolio that was never rebalanced ended up with a roughly 72%-26%-2% split between stocks, bonds and cash, while the most frequently rebalanced portfolio–even having been rebalanced just 5 months ago–was pushed significantly off of its original 60%-35%-5% allocation, ending up with a roughly 65%-31%-4% stock/bond/cash split.

As you can see in the chart above, over the long haul, returns really don’t suffer that much for the more frequently rebalanced portfolios even though they showed lower average returns over shorter periods. In fact the difference in the end value of the never rebalanced and the semiannually rebalanced portfolios was just over 4% after over two decades! That’s hardly an argument for never rebalancing, but it’s not much of one for doing it often, either. Or as former Vanguard Chairman Jack Bogle put it a few years back, “rebalancing is a personal choice, not a choice that statistics can validate.”

Next Time

This week, we ran the numbers and found neither a convincing argument for or against frequent rebalancing–even in volatile markets–but there’s more to the issue than just performance. In our next Adviser Fund Update, we’ll have more on the subject, including key concerns that anyone developing a rebalancing strategy needs to consider, so check back in two weeks.

About Adviser Investments
Adviser Investments operates as an independent, professional wealth management firm with expertise in Fidelity and Vanguard funds, actively managed mutual funds, ETFsA type of security which allows investors to indirectly invest in an underlying basket of financial instruments (these may include stocks, bonds, commodities or other types of instruments). Shares in an ETF are publicly traded on an exchange, and the price of an ETF’s shares will fluctuate throughout the trading day (traditional mutual funds trade only once a day). For example, one popular ETF tracks the companies in the S&P 500, so buying a share of the ETF gets an investor exposure to all 500 companies in the index., fixed-income investing, tactical strategies and financial planning. Our investment professionals focus on helping individual investors, trustsA legal document that functions as an instruction manual to how you want your money managed and spent in your later years as well as how your assets should be distributed after your death. Assets placed in a trust are generally safe from creditors and can be sold by the trustee in short order, avoiding the lengthy and costly probate process., foundations and institutions meet their investment goals. Our minimum account size is $350,000. For the fifth consecutive year, Adviser Investments was named to Barron’s list of the top 100 independent financial advisers nationwide and its list of the top advisory firms in Massachusetts in 2017. We have also been recognized on the Financial Times 300 Top Registered Investment Advisers list in 2014, 2015 and 2016.

For more information, please visit www.adviserinvestments.com or call 800-492-6868.

Disclaimer: This material is distributed for informational purposes only. The investment ideas and expressions of opinion may contain certain forward-looking statements and should not be viewed as recommendations, personal investment advice or considered an offer to buy or sell specific securities. Data and statistics contained in this report are obtained from what we believe to be reliable sources; however, their accuracy, completeness or reliability cannot be guaranteed.

Our statements and opinions are subject to change without notice and should be considered only as part of a diversified portfolio. You may request a free copy of the firm’s Form ADV Part 2, which describes, among other items, risk factors, strategies, affiliations, services offered and fees charged.

Past performance is not an indication of future returns. The tax information contained herein is general in nature, is provided for informational purposes only, and should not be construed as legal or tax advice. We do not provide legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.

The Barron’s rankings consider factors such as assets under management, revenue produced for the firm, regulatory record, quality of practice and philanthropic work. This award does not consider client experience and is not indicative of future performance.

Editors at the Financial Times bestowed “elite” status on 300 firms in the U.S., as determined by assets under management, asset growth, longevity, compliance record, industry certifications and online accessibility.

© 2018 Adviser Investments, LLC. All Rights Reserved.