Rebalancing Myths That Need to Be Debunked
Part of a prudent investment strategy involves rebalancing on an as-needed basis. Rebalancing is the process by which a portfolio's "style drift" caused by market movements is eliminated or minimized. Style drift causes the risk and expected return of the portfolio to change. Thus, disciplined rebalancing is an important part of the winning investment strategy. However, there are two myths we need to address about rebalancing.
Myth 1: Rebalancing Is a Reversion to the Mean Strategy Consider a portfolio with an asset allocation of 50 percent stocks/50 percent bonds. Assume that stocks have returned 10 percent and are also expected to return 10 percent, and bonds have returned 6 percent and are also expected to return 6 percent.
In the first year, stocks return 9 percent and bonds return 7 percent. A strategy that is based on reversion to the mean of returns would sell bonds (since they produced above-average returns) to buy stocks (since they produced below-average returns). However, since the portfolio now would have an asset allocation of greater than 50 percent for stocks, rebalancing would require that stocks be sold to buy more bonds or buy sufficient bonds to increase the bond allocation to 50 percent.
Myth 2: Rebalancing Increases Returns
An example will demonstrate why this myth won't be true most of the time. In most cases, rebalancing will require you to sell some of the higher expected returning asset class to purchase more of the lower expected returning asset class. For example, most of the time we would expect to:
- Sell stocks to buy fixed income
- Sell value stocks to buy growth stocks
- Sell small stocks to buy large stocks
- Sell emerging market stocks to buy developed market stocks
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