(Money Watch) An important part of the winning investment strategy is rebalancing the portfolio. Rebalancing is required because the market's movements cause the value at risk of a portfolio to drift. And as the time horizon increases, it is likely that the allocation to the riskier (and higher expected returning) assets will increase -- increasing the danger to the portfolio. Thus, rebalancing is essential to maintaining the plan's desired allocation.
A second reason for rebalancing is that it impacts the risk-adjusted returns of a portfolio -- a well-diversified portfolio will benefit from the imperfect correlations among asset classes, contributing to lower portfolio volatility. A portfolio that is rebalanced on a regular basis will produce a higher return than the weighted average return of its components. This is often referred to as a "rebalancing bonus," or a "diversification return." Note, this is different than saying a rebalanced portfolio will provide a higher return than one that is not rebalanced. That isn't always going to be the case.
To demonstrate the benefits of rebalancing, Jacques Lussier provided the following example in his book "Successful Investing is a Process" -- a book I recommend for sophisticated investors and investment professionals.
An investor begins in 1973 with a portfolio that is 50 percent stocks and 50 percent bonds. For the period ending in 2010, stocks outperformed bonds as they returned 9.8 percent versus 7.7 percent for bonds. If the portfolio was never rebalanced, the ending portfolio would have had an allocation of 68 percent stocks and the annualized (compound) return would have been 8.9 percent. Knowing that stocks beat bonds by 2.1 percent a year was the investor who never rebalanced better off?
My own experience tells me that most people would assume you would have been better off not rebalancing due to the much higher return of stocks. Yet, a rebalanced portfolio would have returned 9.5 percent, and done so with less volatility. In other words, the diversification benefit was sufficient to overcome the 2.1 percent disadvantage in returns. During this period the annual correlation of stocks to bonds was close to zero (0.1).
Updating Lussier's example through 2012, using the S&P 500 Index and five-year Treasury notes, a typical 60/40 portfolio produced the following results:
- The S&P returned 9.76 percent.
- Five-year Treasuries returned 7.69 percent.
- A 60 percent S&P 500/40 percent five-year Treasury bond portfolio returned 9.38 percent.
A $100,000 portfolio that was never rebalanced would have produced an ending value of just about $3.2 million, with stocks representing 77 percent of the portfolio. A portfolio that was rebalanced annually to maintain the 60/40 allocation would have produced an ending value of about $3.6 million.
The example demonstrates that when you have assets with both high volatility and low correlation you will have a large "diversification bonus." The greater the volatility of stocks and the lower the correlation of stocks to bonds, the greater the excess performance of stocks must be to compensate for the loss of the diversification benefit gained from rebalancing the portfolio. It also demonstrates why rebalancing is such an important part of the winning investment strategy.
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