THE COMPLICATIONS OF REBALANCING

The lessons tied to rebalancing a portfolio’s asset allocation should be simple, but they aren’t. Like every other investing topic, this one too comes with baggage. Although there’s a large body of research suggesting that rebalancing is productive, not everyone agrees. Some of this is about the details, although the basic question of whether rebalancing is worthwhile in concept is debated as well.


Vanguard founder John Bogle, for instance, raised doubts about rebalancing in The Little Book of Common Sense Investing. In essence, he advised that failing to rebalance never costs more than 50 basis points. Meanwhile, not rebalancing may sometimes add 200 to 300 basis points to a portfolio’s return.
Maybe, although the choice of asset classes casts a long shadow over results. Bogle looked at several subgroups of equities and a broad domestic bond index and found that a buy-and-hold/avoid rebalancing strategy worked well. He crunched the numbers over the past 20 years. It’s not obvious that the next 20 will offer a comparable result in terms of returns.
In any case, our own research in The Beta Investment Report shows that owning a broad mix of all the major asset classes, and rebalancing that mix once a year, adds 50 to 100 basis points to total return over time. That’s in line with what some researchers find, such as William Bernstein. In his latest book The Investor’s Manifesto, for instance, he reports that there’s a “rebalancing bonus” of up to 100 basis points for a broadly diversified portfolio over the long term.
But there’s no guarantee. The ideal mix of factors that generate success with rebalancing are hard to control, namely, returns. But you can improve the odds of earning a rebalancing bonus by focusing on what you can control. That starts with owning a broad mix of asset classes. Because the returns of asset classes post lower correlations over time compared to subgroups within an asset class, the odds are better for earning a rebalancing bonus.
Some investors confuse this point by pointing out that that return differences between, say, foreign and domestic stocks, can vary quite a bit at times. That implies that that there’s just as much opportunity in rebalancing within equities as there is across asset classes. But that’s not true. The critical issue is whether returns are highly correlated or not. Within equities, returns are in fact highly correlated. It matters less if one equity group posts dramatically different returns than another vs. the degree of correlation between the two return series. Overall, equity performance tends to move similarly over time, even if the changes exhibit a wide variety.
By contrast, correlation of returns between stocks and bonds, or commodities and bonds, REITs and bonds, etc., tend to be lower as a general proposition. Therein lies the foundation for expecting a rebalancing bonus. There’s more to the story, of course, as we explain in some detail in our book Dynamic Asset Allocation. But the basics begin with correlation.
Of course, there’s also the question of timing and magnitude. That is, how often should you rebalance, and under what conditions? The answers are complicated and well short of definitive. Sure, you can enhance the rebalancing bonus by adjusting the timing and magnitude. But you can also give up return if you misjudge the markets. There’s a fair amount of subjectivity on these topics in terms of what’s likely to work, or not.
This much, at least, is clear: If you own fewer asset classes, you’ll have to rely more on timing and magnitude to generate a rebalancing bonus. In turn, success with adjusting timing and magnitude requires more skill vs. a naive, mechanical rebalancing strategy across broad asset classes.