Portfolio rebalancing is likely among the most mundane components of investment management. Rebalancing will never be as exciting as selecting the stock that doubles over the course of a few weeks. Nor will it replace the feeling of piecing together a new outlook from mosaic theory. It is the easy “checkdown pass” of the investing process. Taking what the defense gives you is usually not as exciting as a deep, downfield pass. That said, it is often the smart play if you want to stay in a manageable situation.
Over time, portfolio allocations drift. This is because different investments have different returns. Let’s imagine it is January 1st, 2004. Let’s also imagine your risk tolerance allows for a $1 million portfolio with a simple allocation of 50% large US stocks (as represented by the S&P 500) and 50% US investment-grade bonds (as represented by the Bloomberg Barclays US Aggregate Bond Index). How would that portfolio perform under a non-rebalanced strategy as opposed to management with annual rebalance at the end of each year?
The table below shows the results. A risk mitigation strategy requiring only two trades a year saved the portfolio over $20,000. The rebalance forced the portfolio to limit equity risk exposure going into 2008. That allocation shift dampened the loss experienced in what was a very poor year for equities. Meanwhile, the un-rebalanced account entered 2008 with what amounted to a relative overweight to equities of almost 10%.
I will confess this examination focuses on a particularly tough time to be overweight equities. That said, this is the type of environment where risk mitigation is meant to shine. The benefits continue even beyond the end of the period shown in the chart. Going into 2009, the un-rebalanced portfolio’s equity allocation would have fallen below 42% of the portfolio. That would be disappointing going into a year when the S&P 500 returned over 26%. Meanwhile, the rebalanced portfolio would have bought equities back up to target after 2008 for a full 50% allocation entering 2009.
There are costs to consider in rebalancing. Factors such as tax consequences, transaction costs, and shifting risk-return expectations impact our thought process. At the risk of pushing the football analogy too far, a checkdown pass can be a poor play if a linebacker is lying in wait to intercept. As we implement an investment plan, you can be sure we will be careful to read the whole field.