As a passive investor, and a financial advisor who exclusively uses passive investing strategies for clients, I am wary of all reasons the average investor lags the overall market. One such reason is infrequent rebalancing.
Here's the key takeaway: ideal rebalancing practices can yield up to 0.5% annually. For a $1M portfolio, that could add $438,000 over 25 years – potentially pulling forward retirement by several years.
What Exactly Is Rebalancing?
Skip this section if you already know. Passive investing involves picking a small group of funds and allocating your portfolio to each at a certain percentage. Over time, different funds grow differently. What ends up happening is that the ratios of funds will drift away from the original strategy. Rebalancing involves selling relatively appreciated assets and buying relatively unappreciated ones to maintain a desired asset allocation. Simple.
Why Rebalance?
It is tempting to stick with a stock that has performed well, and just might continue to do so.
But there are two two big advantages to regular rebalancing. The first, is to control risk. A 50-50 stock-bond portfolio in 1926, with dividends/interest reinvested in like assets, drifted to a 97-3 mix by 1990! That is unacceptably much in stocks if you are in retirement. Restoring the original allocation keeps your risk exposure in line with your financial plan.
The second benefit comes through opportunities to sell high & buy low. This is built right into the mechanism of rebalancing. Assets that do well become a bigger share than intended. By selling these assets and buying less favored ones, you are constantly taking advantage of temporary mis-pricing in the marketplace.
The Geeky Details
Much of what follows is based on two well-known articles cited below.
Rebalancing does more to reduce risk than to enhance returns
But you do get about 0.5% benefit on average, compared to never rebalancing
More volatility brings better results from rebalancing
Professional investment managers tend to rebalance more frequently than individual investors
Several different methods of rebalancing have been widely tested over decades
Calendar based (rebalance every month/quarter/year)
Tolerance range based (rebalance when an asset’s percentage exceeds a certain level)
The best rebalancing outcomes are achieved through what is called “Opportunistic Rebalancing” – where the portfolio is tested daily but only rebalanced if any asset is outside a 20% tolerance range for its percentage. This results in 0.5% improvement in performance compared to no rebalancing, and 0.24% better than an annual, calendar based rebalancing.
This chart shows average return benefit to rebalancing. Look Intervals mean how often you check for rebalancing conditions. Rebalance bands are how much deviation you should tolerate for any given asset's allocation. Here, the best results are in yellow - where you check daily, but only rebalance if an asset is more than 20% off its target allocation.
Rebalancing more frequently yields better results - all the way down to daily checks
There are transaction and tax costs to rebalancing. However, they are small compared to the benefit from rebalancing. Today, most brokers offer no-fee transactions. When tested in taxable accounts, tax costs were less than 10% of the overall benefit of rebalancing. About 0.05% compared to 0.50% in benefit.
Portfolios with higher exposure to stocks see greater benefit from rebalancing
How To Implement Rebalancing Well
Calendar based rebalancing is very easy to implement. For most 401k accounts, it is as easy as setting the rebalancing frequency to Annual. If you self-manage your taxable accounts, set an annual calendar reminder, and rebalance your accounts manually.
However, not all brokerage platforms offer the technology needed for Opportunistic Rebalancing. There are, however, some tech-forward brokers that offer auto-rebalancing tools like daily testing and tolerances ranges.
At Artham, we partner with Altruist, just one such broker. Altruist was built, ground-up, by former financial advisors. They have done a lot to bring technology to bear to implement evidence-based methods of managing investments. Here's their white-paper on the same topic.
At 0.26%, the potential upside to Opportunistic Rebalancing can be worth a lot of money and could justify a change of brokerage. Drop me a note if you want to discuss auto-rebalancing.
Sources
“Rebalancing: Why? When? How Often?”, Arnott, Robert and Lovell, Robert, First Quadrant Group, 1992
“Opportunistic Rebalancing: A New Paradigm for Wealth Managers”, Daryanani, Gobind, Journal of Financial Planning, 2008
This material is intended to be of general interest, not personal financial advice or a recommendation to buy, sell or hold any security or adopt a particular investment strategy. Your circumstances and attitudes toward risk matter, and only an advisor working with you can give you specific advice. All investments carry the risk of loss, including loss of principal. Stock and bond prices can be volatile. Past performance is not an indicator or guarantee of future results. Diversification does not guarantee profit or protect against risk of loss. This material may not be reproduced, distributed or published without prior written permission from Sanjay Pamurthy/Artham Advisors LLC. Data from third party sources quoted here has not independently verified, validated or audited. Although information has been obtained from sources that Artham believes to be reliable, no guarantee can be given as to its accuracy and such information may be incomplete or condensed and may be subject to change at any time without notice. Artham accepts no liability whatsoever for any loss arising from use of this information and reliance upon the comments, opinions and analyses in the material is at the sole discretion of the user.
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