Rebalancing: It’s Still A Great Way to Manage Risk
By James Picerno, Director of Analytics
There’s no shortage of strategies that are intended to help keep the risk inherent with investing under control. One of the oldest, most widely used and most effective is rebalancing.
Rebalancing involves periodically buying or selling assets in a portfolio to maintain predetermined asset allocations. In other words, investments whose current value has drifted above the target weight of the account are sold, and the proceeds are reinvested in investments whose current value is lower than originally intended.
Morningstar notes that “rebalancing your portfolio is one of those beneficial habits - like flossing every day or dusting under the refrigerator - that’s easy to let slide,” the consultancy recently advised in an updated review of the strategy. “But if your portfolio’s equity exposure crept up over the past few years, the sudden market correction in February and March was a harsh reminder of why it’s a good idea.”
Once you’ve made the commitment to implement a rebalancing program, the next decisions are how and when to rebalance? The good news: effective rebalancing doesn’t have to be complicated or sophisticated. A simple plan to reset weights on a regular schedule can be quite effective.
As an illustration, the recent Morningstar article reviews results for a simple 60%/40% stock/bond portfolio. For the trailing 15-year period through this past May 31, for example, it’s instructive to consider how a buy-and-hold version of the strategy fared against several flavors of rebalancing from a risk (return volatility) and performance perspective.
As the following chart shows, rebalancing for this simple example came with a price tag in the form of modestly lower return. But the reduction in performance is also associated with a considerably bigger drop in risk (volatility). The buy-and-hold portfolio earned 7.61% a year with a near 10.2% annualized standard deviation. Several different rebalancing frequencies trimmed the return slightly (roughly to a 7.25%-to-7.55% range). Note the larger reduction in risk – from about 10.2 to under 8.8.
To be sure, as this basic example illustrates, in this year’s dramatic correction a simple rebalancing strategy probably reduced volatility only modestly. Rebalancing, in other words, is no silver bullet. But when paired with a reasonable asset allocation and a schedule of periodically resetting weights, rebalancing remains the first choice for managing portfolio risk.
Note, too, that simple, calendar rebalancing strategies can be enhanced. The devil’s in the details, of course, and it’s easy to fall into the trap of thinking that there’s an easy solution to avoiding the deepest market drawdowns without sacrificing return. But with careful research and testing, there are opportunities for improving on standard rebalancing strategies.
Ultimately, it’s essential to manage expectations. No matter how sophisticated the methodology, it’s naive to expect that rebalancing alone will double your portfolio’s Sharpe ratio without materially reducing return, or substantially ramp up performance with little or no commensurate increase in risk. But as a foundation for prudent risk management, rebalancing is a great way to start.
If you’re not sure how to begin, start with a simple baseline. Vanguard suggests a reasonable starting point: “Check your portfolio at least once a year, and if your mix is off by at least 5 percentage points, consider rebalancing.”
(An earlier version of this article was originally posted on The Capital Spectator on July 16, 2020.)