What You Should Know About Rebalancing

MoneyWatch TalkbackShare your ideas and expertise on this topic

Subscribe to this discussion via Email or RSS

•  
  1

  ajwillms

  10/23/09 | Report as spam

  AJW

  Larry, in your books and your comments to your earlier article, you discuss the importance of rebalancing for style drift. However, worrying only about style drift, it seems to me, assumes that the risk of the asset classes that comprise a portfoilo remain constant. Of course, we know that as an asset class' volatility increases, so does the risk associated with that asset class. Likewise, over time different asset classes can become more or less correlated, which in turn can raise or lower a portfolio's total risk.
  
  As a result, a portfolio that is rebalanced only for style drift can be more or less risky than when inititiated due to what I refer to as "risk drift". Likewise an investor's risk tolerance can change over time, depending on age, net worth, anticipated financial needs, etc.
  
  Therefore, I beleive it is important to periodically check an asset allocation's level of risk, and to adjust the allocations as need be to match the portfolio's inherent risk to the investor's current risk tolerance. Do you agree?

•  
  2

  larry swedroe

  10/23/09 | Report as spam

  RE: What You Should Know About Rebalancing

  AJW
  Great question.
  
  First, a rebalancing table with targets and minimums and maximums should be a written part of the overall investment policy statement (IPS).
  
  Second, a IPS is, or should be, a living document, not a static one that is written once and that's it. Since the IPS should be based on one's ability, willingness and need to take risk, any time any of the assumptions relied on to make the AA decision have changed the IPS should be reviewed and changes made as needed. Simply the passage of time changes the ability to take risk. And changes in job status, divorce, death, inheritance and so on can impact the ability, willingness or need to take risk. And it is also possible that an investor is overconfident of their ability to withstand the stress of a bear market. And if they learn that they made a mistake only a fool would continue to repeat a behavior they learned was wrong.
  
  Third, even major market moves can change the NEED to take risk. Bull markets lower it for those who already have substantial assets but raise it for those in the early stage of their investment career (because future expected returns are now lower). And bear markets do the reverse. Thus, if the market's realized returns are significantly different than they expected return built into the IPS then the IPS might have to be altered accordingly---or other changes made (such as working longer or saving more).
  
  Fourth, as to correlations drifting. That of course is true, something too many investors fail to understand and that causes them to abandon well-thought-out plans. What they need to know is that in crises the tendency is that the correlations of all risky assets will go toward one. But once the crisis is resolved they fall again. So personally I would only use very long term data on correlations and not alter an IPS due to short term drifts. The fact that correlations will tend to rise toward one (for risky assets) should be part of the plan---making sure that you have a sufficient amount of high quality fixed income (not junk bonds, not preferred stocks, not convertibles, not EM bonds, none of which IMO have a role in a portfolio--they are not needed) to reduce the risks of the overall portfolio to an acceptable level.
  
  So bottom line is the only reason to rebalance is because of style drift, but there are many reasons that could cause one to alter their IPS thus their rebalancing table.
  
  I hope the above is helpful

•  
  3

  ajwillms

  10/23/09 | Report as spam

  AJW

  Very much so. Thanks.

•  
  4

  dawg999

  10/25/09 | Report as spam

  RE: What You Should Know About Rebalancing

  Larry,
  
  Are there any studies that quantify how much rebalancing can add to your overall return?
  
  Thanks.
  
  Steve

•  
  5

  larry swedroe

  10/25/09 | Report as spam

  RE: What You Should Know About Rebalancing

  Steve
  
  First, to repeat you do not rebalance to improve returns, but to restore the appropriate AA.
  
  Second, as I stated, if you have a portfolio that is stocks and bonds, most of time when you rebalance you will be lowering expected returns, since most of time you will be selling the higher expected returning asset class and buying the lower expected returning one. Just think of say a 50/50 portfolio of S&P 500 and say 5 year Treasuries starting in 1990 and ending in 1999. Clearly better off if never rebalance.
  
  Third, what rebalancing does do is that the portfolio's return will be greater than the weighted average return of the components. How much greater depends on the correlations and volatility of the assets in the portfolio. Negative correlation and high volatility gets you the greatest "diversification return" or "rebalancing bonus."
  
  I hope the above is helpful
  
  

•  
  6

  CAM Advisor

  10/26/09 | Report as spam

  RE: What You Should Know About Rebalancing

  Larry,
  
  There was a white paper put out by DFA sometime in the last year (I think) regarding the rebalancing question. They talked about the advantage or disadvantage of rebalancing daily vs. annually. Pretty interesting.
  

•  
  7

  larry swedroe

  10/26/09 | Report as spam

  RE: What You Should Know About Rebalancing

  CAM that paper focuses on RETURNS, which is NOT what rebalancing is about. If it was about returns then we would only rebalance when we would be expected to raise returns, not lower them.
  
  Rebalancing should be about managing RISK, not returns.
  
  And as I said, in the absence of transactions costs the only logical answer is to rebalance DAILY--otherwise you have the wrong AA to begin with. But we do live in a world of transactions cost (including the value of time), so risk-based, not time based, rules should be adopted.
  
  At least that is my view
  
  Best
  Larry

•  
  8

  jon 2020

  10/27/09 | Report as spam

  RE: What You Should Know About Rebalancing

  My 401k is very flexible--I can set it to automatically rebalance on an arbitrary schedule (daily, weekly, monthly, whatever), with no transaction cost. So I would really like to understand the best approach based on research.
  
  Isn't the research pretty solid that markets have a momentum component, and that returns will be higher if rebalancing is not done too often? Why ignore diversification return -- isn't it a free lunch similar to overweighting small value?
  
  Similar to the approach you've taken with small value, wouldn't it be better to have a slightly lower equity exposure, but rebalance less often. The latter provides a better risk/return profile, so one can the same return with a lower equity exposure?
  
  

•  
  9

  larry swedroe

  10/27/09 | Report as spam

  RE: What You Should Know About Rebalancing

  Jon
  
  I agree if you don't rebalance as frequently --assuming you have asset classes with different expected returns--you will be better off rebalancing less frequently if your objective is to maximize returns.
  
  
  AS I stated I believe it is reasonable to allow some moderate/acceptable drift and one reason is costs matter. But if you have zero costs then it should be simple logic to keep AA the same or you have the wrong AA. Why is 50/50 right one day but next day 51/49 is better? That cannot be right.
  
  

•  
  10

  jon 2020

  10/28/09 | Report as spam

  RE: What You Should Know About Rebalancing

  I see the logic that AA should change only if one's long-term financial plan changes. But if sticking to an AA on a daily basis degrades the risk/reward trade-off, then one must unnecessarily increase risk in the AA meet the financial plan, which is not a logical strategy.
  
  Maybe I am thinking about this too hard -- probably the difference between rebalancing daily vs yearly is not enough to fret about.
  
  thanks!
  
  

•  
  11

  larry swedroe

  10/28/09 | Report as spam

  RE: What You Should Know About Rebalancing

  John
  
  I would not bother with daily rebalancing
  
  My suggestions are to
  a) always rebalance when have new cash
  b) set ranges around which you are willing to tolerate some movement, might use my 5/25 rule described in my books. Or set it for something more like quarterly--that way you gain from any momentum but don't let AA drift too much.
  
  Give you bit more time to enjoy your life perhaps
  
  Best
  Larry