Portfolio Rebalancing – The Effects of its Systematic Implementation

Investors buy and sell financial instruments, often influenced by media reports and public sentiment. However, through decades of research, scholars have largely concluded that any information publicly available is already reflected in asset prices, resulting in an expected return to zero at any given point in time. The economist John Maynard Keynes even described perceived information as merely noise. In contrast, professional financial managers distinguish themselves from these “noise traders” by employing periodic portfolio rebalancing to systematize and bring discipline to their investment processes. The question remains: does this approach introduce predictability to investments?

To perform portfolio rebalancing, one needs predefined asset allocation targets, such as 60% stocks and 40% bonds, and the process involves adjusting the portfolio back to these target allocations when it drifts away from them. For example, when the stocks in the portfolio appreciates to 70% at the end of the year, one would sell a portion of it and invest in bonds and bring back the portfolio to the original target. Wealth managers widely recommend this practice suggesting that it allows investors to buy assets when they are undervalued and sell them when they are overvalued, potentially benefiting all investors. The aim of this article is to assess the validity of this presumption, and make a casual examination of portfolio rebalancing and evaluate whether it is suitable for every investor.

To gain a better understanding of the effects of portfolio rebalancing, I conducted exercises to measure the growth of $10,000 in a portfolio consisting of 60% US stocks and 40% bonds. The exercise is divided into two separate groups. The first group comprises portfolios only with 20-year holding periods, assessed on a rolling-year basis spanning from 1975 to 2023. These portfolios start with the period 1975-1994, followed by 1976-1995, and so on, ending with 2004-2023. The second group comprises portfolios with different starting years and varying holding periods, but all of them end in the year 2023. These portfolios start with the period 1994-2023 (30-year holding period), followed by 1995-2023 (29-year holding period), and so on, ending with 2022-2023 (2-year holding period). Most importantly, to observe the effects of rebalancing, each portfolio in both groups is evaluated under two scenarios: with or without annual rebalancing.

In the first group, in which all portfolios have a 20-year holding period, 60% of those that underwent rebalancing ended with a higher value compared to those that were not rebalanced. For instance, consider the portfolio rebalanced annually from 1994 to 2013. It had an ending value of $51,077, which was 8% higher than the non-rebalanced portfolio with an ending value of $47,354.

Second group: All ending in 2023 with various starting years (n=29)
Ending value with rebalance > no rebalance	17%
Standard deviation with rebalance < no rebalance	93%

In the second group, in which all portfolios end in 2023 but have different starting years, the rebalanced portfolio had a higher value than the non-rebalanced portfolio only 17% of the time. For instance, consider the portfolio with the longest holding period, starting in 1994 and ending in 2023. The rebalanced portfolio had an ending value of $105,375, which was 9.6% lower than the non-rebalanced portfolio, with an ending value of $116,556.

From this exercise, I have observed the following points:

1. Rebalancing reduces the effects of market downturns, and allows investors to buy undervalued assets, potentially benefiting from market recoveries.
2. Rebalancing could lead to lower returns during market upturns, as it can curtail the extent of stock gains by selling them when there is continued upward momentum.
3. Rebalancing to result in better returns than not rebalancing occurs by chance, and the timing of assessment plays a critical role.
4. Rebalancing reduces portfolio volatility.

The two aforementioned portfolios that start in 1994 can help illustrate the first two points. In the portfolio that begins in 1994 and ends in 2013, a few years following the Great Recession and in the midst of economic recovery, rebalancing results in a higher ending value compared to not rebalancing. However, when the holding period is extended to 2023, during which the Federal Reserve increased money supply by record amounts followed by a surge in asset prices, not rebalancing produced a higher ending value than rebalancing, reaping the full benefit of easy monetary policy.

The results of these exercises demonstrate that an individual’s perspective on portfolio rebalancing may change depending on when they conduct their assessments. While the likelihood of achieving positive returns on investments from rebalancing appears to be largely due to luck, as supported by academic research, one clear benefit observed in the exercises is a reduction in portfolio volatility. In both groups of exercises, rebalancing led to a reduction in standard deviation more than 85% of the time compared to not rebalancing.

In conclusion, it is evident that portfolio rebalancing is not a one-size-fits-all solution. While the ending value as a result of rebalancing is not predictable, it reduces portfolio volatility with a high probability. Therefore, the decision to utilize it depends on an individual’s sensitivity to market downturns and their life stage. As individuals enter advance age, they may become more risk-averse, and in such cases, portfolio rebalancing can offer a more agreeable investment experience by reducing volatility and controlling risk exposure in stocks. On the other hand, those in the accumulation stage with no immediate need to withdraw funds from their portfolio may benefit from not rebalancing.

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