The Independent Adviser for Vanguard Investors
•
February 2016
•
13
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because over long periods of time you
tend to sell assets with greater return
potential (stocks) to buy something that
will likely return less (bonds).
To say that there are myriad rebalanc-
ing strategies foisted upon the investing
public would be a vast understatement.
The two most common rebalancing
schemes focus on either the calendar
(instructing investors to rebalance every
month, six months, year, or three years)
or on how far your portfolio allocation
skews beyond a percentage threshold
you’ve established, say 5% or 10%.
Vanguard published a whitepa-
per,
Best Practices for Portfolio
Rebalancing
, which examined various
rebalancing strategies. In the end, the
authors recommend combining the two
standard approaches: Review your port-
folio on a periodic basis, and if the
portfolio allocation has skewed 5% at
that time, then rebalance.
Here’s the issue: While these sugges-
tions sound great on paper, in the real
world their efficacy is suspect. Let’s
take each recommendation in turn.
Time-Dependent Rebalancing
Let’s start with the impact of time-
dependent rebalancing on the same
50/50 stock/bond fund portfolio I
described above.
I have set up a few rebalancing sce-
narios. In the first, I rebalanced the port-
folio every six months—once in January,
and again in July. In the second test, I
rebalanced once a year in January, and in
the third I took the long view and rebal-
anced every third January. Naturally, I
also compared the results of these strate-
gies with the “never rebalanced” portfo-
lio. (Also, you may be wondering why I
picked January for rebalancing. I figured
that if it’s a mechanical system, it’s best
to make your trades after December dis-
tributions have been paid out and the tax
year has turned.)
What you can see in the chart above
is that after nearly 30 years through the
end of 2015, the differences between
several regular rebalancing strategies
and the no-rebalancing strategy are
pretty minor. And, other than at market
extremes, like the late-1990s period
before the bursting of the tech bubble
and the decline from the top of the
market in October 2007, it’s pretty hard
to distinguish one line in the chart from
another.
The data in the table below confirms
it. Whether you are comparing the
total returns, the rolling one-, three-
and five-year returns or the maximum
cumulative losses (MCL) between the
rebalancing strategies over the entire
period, you can’t definitively say that
one rebalancing method trumps anoth-
er. And, as I said at the outset, rebalanc-
ing is all about controlling risk. Each
rebalancing strategy yielded a mean-
ingfully smaller maximum cumulative
loss (MCL) than the 34.5% decline
suffered by the no-rebalancing strategy.
However, all slightly underperformed
the no-rebalancing portfolio, though
the differences were tiny. For instance,
the annual rebalancing strategy gener-
ated a total return over the entire period
that was just 5 basis points, or 0.05%,
per annum off the pace of the no-
rebalancing strategy. On a $100 initial
investment that translates into a differ-
ence of $14 at the end of the 29-year
period—$1,067 vs $1,054.
A non-trivial piece missing from my
calculation is the impact of taxes from
rebalancing’s trading activity. Assume
even a small amount of taxes, and
the rebalancing strategies fall further
behind the no-rebalancing strategy in
terms of total performance.
So, from a volatility and drawdown
standpoint, rebalancing does have a
risk-reducing effect on a portfolio if
you happen to go through a big enough
bear market—you won’t hit the same
interim heights, but neither will you
experience the same interim losses.
HittingYourThreshold
Okay, that’s the periodic rebalanc-
ing strategy. What about the one that
says you should rebalance when your
allocations are 5%, or even 10%, out of
whack? This is a popular recommen-
dation, but the results really aren’t all
that different from the calendar-based
approaches.
Again, I took a 50/50 portfolio and
set up two scenarios beyond simply
Rebalancing’s Benefits Are Minimal
Semiannual
rebalancing
———— ROLLING RETURNS ———— Terminal
Value of
$100
Annualized
Return
Basis
Pt.
Diff.
MCL
1-month 1-year 3-year
5-year
Best
7.3% 30.2% 20.6% 17.9%
Average
0.7% 8.7% 8.6% 8.4%
Worst
-9.7% -22.2% -4.8% -1.0% $1,031
8.37% (13)
-26.1%
Annual
rebalancing
Best
7.3% 30.9% 20.8% 18.1%
Average
0.7% 8.8% 8.7% 8.5%
Worst
-11.3% -21.3% -4.5% -0.8% $1,054
8.45% (5)
-25.2%
Rebalancing
every 3 years
Best
7.3% 32.0% 21.6% 18.7%
Average
0.7% 8.7% 8.6% 8.4%
Worst
-11.3% -19.4% -3.8% -0.3% $1,024
8.35% (16)
-23.6%
Never
rebalancing
Best
7.7% 36.6% 24.0% 21.3%
Average
0.7% 9.1% 8.8% 8.4%
Worst
-11.8% -28.5% -9.0% -2.6% $1,067
8.50% — -34.5%
Note: Multiyear returns are annualized.
>
Rebalancing Is
About Risk
12/87
12/91
12/95
12/99
12/03
12/07
12/11
12/15
Note: Calendar-based rebalancing strategies.
Semiannual
Annual
Every 3 Years
Never
$0
$200
$400
$600
$800
$1,000
$1,200