The Rebalancing Effect

Does rebalancing your portfolio annually create additional return potential and lower volatility versus never rebalancing?

Investing is the ultimate exercise in patience. Historically, major equity and bond markets have delivered positive returns for investors who use a patient, long-term strategy. However, to realize those potential long-term benefits, investors often have to navigate through periods of short-term uncertainties.

An undisciplined approach to trading decisions, particularly during volatile market conditions, can negatively impact performance and make for a difficult investing experience.

However, rebalancing your portfolio annually may create additional return potential and lower volatility versus never rebalancing.

For a long-term investor, patience and risk management are key qualities. But patience is different than inattention. Maintaining a mix of investments that deliver returns and manage risk requires timely adjustments, since, over time, there are three common occurrences that can shift a portfolio away from its initial asset allocation.

1. Performance - As assets rise or fall in value, their weights also change based on how they have performed relative to the portfolio. For example, if one asset performs extremely well, while another fares poorly, over time the well-constructed portfolio becomes heavily weighted toward the well-performing asset. Investors who don’t rebalance may find themselves overexposed to rich asset classes and underexposed to cheap ones.
2. Behavior biases – Often, even the smartest investors will make emotional or irrational decisions when it comes to choosing assets. Investors will allocate capital to assets that have performed well, in hopes the asset will continue performing. Emotional decisions can also cause investors to sell asset classes when their markets have declined. Emotional views of performance do not constitute well-reasoned investment opinions. Left unchecked, these decisions can affect allocations and potentially harm performance. 1
3. Unbalanced Income Reinvestment - Investors sometimes reinvest income produced by a specific investment product back into that same product. While reinvesting income within the portfolio can build more value more effectively than distributing the income, it skews weights toward classes with greater income-generation potential.

A key to addressing these issues is an annual rebalance of your portfolio. Rebalancing portfolios annually may not only generate additional return potential, it can lower volatility versus never rebalancing.

Over the very long term, and with a yearly rebalancing regime, recent work2 has shown how volatility can be “harvested” to help build wealth. The interactive chart below shows two long-term constructions of domestic stock and bond portfolios of different mixes. If you look at their values after 20-plus years, you’ll see that the rebalanced version has significantly outperformed the version that was not rebalanced. In addition, a 60% stocks/40% bonds portfolio rebalanced annually has actually outperformed a static 100% stock portfolio.