The case for rebalancing your portfolio

(MoneyWatch) As the end of the year approaches, it's tempting for investors to look at what has performed well in the past 12 months and buy more of that asset class, expecting those above average returns to continue. That is the mistake of "recency." It was Spanish philosopher and novelist George Santayana who said: “Those who cannot learn from history are doomed to repeat it.” Hopefully, the following information will prevent you from repeating the mistake of recency.

For the 17-year period from 1983 to 1999, the Wilshire REIT Index (which measures U.S. publicly traded Real Estate Investment Trusts) returned 9.2 percent. This return allowed one dollar invested to grow to $4.45. Then from 2000 to 2006, REITS returned 23.1 percent per annum. The result was that in just seven years one dollar invested had grown to $4.29, or almost as much growth as it had produced in the preceding 17 years. In addition, the growth to $4.29 in just seven years is eerily similar to the growth of a dollar to $3.90 that the large-cap growth sector produced from 1995 through 1999. 

The importance of discipline

The academic evidence demonstrates that the determinant of almost all of the risk and return of a portfolio is its asset allocation. It is important to add that, because of recency, the most important determinant of the return that an investor’s portfolio actually produces might be the ability to adhere to whatever the asset allocation the investment policy statement called for. In other words, discipline to adhere to a plan can be more important than the plan itself.

Wise investors know that while reversion to the mean is a powerful force, trying to trade on that information is a loser’s game. One reason is that streaks of abnormally low or abnormally high returns can continue for a long time. The following insightful quote has often been attributed to John Maynard Keynes, perhaps the most famous economist of modern times: “The market can stay irrational longer than you can stay solvent.”

Let’s look at some further evidence that trading strategies based on market valuations don't work.

Studies have found that when the spread in book-to-market ratios between value stocks and growth stocks is high, the subsequent value premium tends to be high. The reverse is also true. Based on that information, if next year’s value premium is expected to be high, it would seem logical to own value stocks. If it is expected to be low, then growth stocks become the logical choice. Is it really that simple to earn abnormal returns?

Does a statistical relation always translate into a viable portfolio strategy? These are the questions Jim Davis, vice president of Dimensional Fund Advisors, asked and answered in a study that covered the period July 1927 to June 2005. (Full disclosure: My firm, Buckingham, recommends Dimensional funds in the construction of client portfolios.)

Davis found that style-timing rules did not generate high average returns despite being able to use future information about book-to-market spreads. In fact, he concluded that that the expected excess return of style timing is probably negative.

The lesson for investors is that just because a statistical relation exists does not necessarily imply that a profitable trading strategy based on that relationship exists, especially after taking into account trading and other costs. The bottom line for investors is that the prudent strategy is to adhere to your investment plan. However, that does not mean doing nothing.

The winning strategy

The winning strategy includes disciplined rebalancing of your portfolio. Rebalancing is the process of eliminating the style drift caused by the market in order to restore your portfolio to its original asset allocation.

For example, consider a portfolio that consisted of only the two asset classes we have been discussing, U.S. large-cap growth stocks and REITS and allocates half  the money to each. During the period 1995 to 1999, when large-cap growth stocks were returning 31.3 percent, REITS were returning just 8.3 percent.

Disciplined investors would have been doing the following: At the end of each year (except 1996 when REITS outperformed large-cap growth stocks) they would have sold some of the large-cap growth holdings and increased their REIT holdings in sufficient quantities to restore their desired 50:50 allocation. The reverse process would have occurred in every year from 2000 through 2006. They would have been selling some of their REIT holdings and increasing their large-cap growth holdings.

In each case they would have been “leaning against the winds of emotions” (and recency). In other words, they would have been buying relatively low and selling relatively high -- a much better strategy than the one that results from being subject to recency.

In summary, the winning strategy is disciplined rebalancing -- restoring your portfolio to the asset allocation you decided was the most appropriate when you developed a carefully thought out plan. Remember, high returns lower future expected returns, and vice versa.