All about rebalancing.
So far on my blog, I’ve written about portfolio rebalancing quite succinctly and only as part of other posts. Since this is an important topic, I decided to dedicate a separate, albeit short (yes, I’m learning!) post to this process to share my thoughts on this topic with my readers. Rebalancing, as it is called in English, is a topic that I think is taken a bit “too seriously” by beginners, who want to always stick to the set proportions of their portfolio at all costs, sometimes not caring about the trading commissions and the lost time they devote to this process. In today’s post, I will not only answer the question of whether it is worthwhile to rebalance your investment portfolio proportions, but also the “how?”, “when?” and “why?”.
If this post is the first one you’ve read on my blog and you’re a long way from figuring out the proportions of the components of your future portfolio, I encourage you to also read “What to Invest 10K in? The First Investment Portfolio”, in which I describe some simple ideas for an investment portfolio. In order to balance the ratios you first need to have something to balance, because theory is only theory and the real hardships of running an investment portfolio will come only after you have created it. If you are an inexperienced investor and are just looking for a way to balance your portfolio in the most favorable way, you will find the suggestions and comments I have listed at the end of this post useful. Let’s start with what rebalancing even is and why most investors do it sometimes.
What is rebalancing?
The seemingly simple process of rebalancing a portfolio is often misunderstood as something it is not. Most passive investors set themselves a certain desired proportion of their portfolio, say 60% stocks and 40% bonds, for the next X (or XX) years in an effort to maintain the chosen proportion. On paper it sounds very simple and since for about 80% of the time stocks will do better than bonds, the whole process will consist of selling stocks at the expense of bonds, which will be too few in the portfolio. The definition of rebalancing could therefore be “to periodically bring the proportions of the components of one’s portfolio into line with those previously chosen in one’s strategy”, which in graphical form for a 60/40 portfolio would look as follows:
In rebalancing, the idea is to reduce the volatility of the portfolio when the stock market rises, “moving” part of the capital into bonds, so that later – when the stock market falls – you have something to “buy cheap shares” with. Of course assuming that we keep the chosen proportions, because very often I write and talk with investors, for whom the temptation of increased profit is more important than a peaceful night’s sleep and they break the previously established rules, assuming that the crash will not come, so it makes no difference whether they have 60% or 85% of shares in their portfolio. For many people, rebalancing an existing portfolio can be cumbersome, as the brokerage commissions on buying and selling assets and the time that this process consumes can prove to be the overwhelming argument against doing it. Fortunately, rebalancing can also be done using only the incoming capital, which I will describe in the next paragraph of this text.
What if we run a portfolio with infrequent, e.g. annual, contributions or the size of the portfolio is so large that regular contributions can no longer balance the portfolio on their own? In such a case, we have to perform a classic portfolio rebalancing, which consists in selling a part of an asset that is “too much” and using the obtained funds to buy an asset that is “too little”. However, it is worth remembering that it is sometimes cost ineffective (overpaying brokerage commissions) and tax ineffective (making a profit, and thus having to pay tax next year), so whenever we can we should decide to rebalance with new contributions. We’ve come to an important point in the blog post where I’ll give you an overview of when I think it’s a good idea to rebalance and why.
When is it worth doing rebalancing?
In my opinion rebalancing a portfolio too often will be a waste of time for most portfolios. For the time being, I left out one important fact in the post, which is that the “when” can depend on time, but also on the ratio deviation. For example:
The first option is to determine the frequency with which we will rebalance (e.g., once a year, once a quarter, or once a month). In this case, you usually aim for the ideal, rebalancing the portfolio regardless of whether it deviated from the pattern by 1%, 2%, 5%, 10%, or more.
The second option is to set yourself a percentage deviation at which you will rebalance. It is not based on time but on changing the proportion of the portfolio, so it is performed only when it is needed and not, for example, every six months and regardless of the deviation.
Personally, what appeals to me most is a hybrid of both solutions, i.e. checking the deviation every quarter, but rebalancing the components only if the proportions of my portfolio “escaped” by 10% from the intended ones. In the next section, I’ll show you how rebalancing the proportions of a balanced 50/50 portfolio would affect long-term investment returns.
Rebalancing a 50/50 portfolio in practice
In this short chapter, I’ll show you how rebalancing would work for a simple portfolio consisting of 50% U.S. stocks and the other 50% U.S. Treasury bonds over the last 40 years, i.e. from 1980 to 2019. The data I’ll present was obtained using System Trader software and is based on 40 years of the S&P500 Total Return index (i.e. one in which dividends from companies were reinvested in “units” of the index) and 30-year U.S. Treasury bonds, i.e. those with the longest maturity.
Rebalancing in good years for stocks
We will now perform a similar simulation, but assume a much more optimistic decade for the stock market, because instead of an average annual return for stocks of 1.7%, it will be 11.5%. The rates of return for the simulation will be respectively:
- Average annual return for stocks: 11.5% (previously 1.7%). It was enough to
- reverse the signs at the rates of return in years 3 and 10 ;-).
- Average annual rate of return for bonds: 3,15%
- The rates of return for bonds will not change, and we will get the effect of the increase on stocks by changing the sign in years 3 and 10 (from -30% to +30% and from -15% to +15%), which I marked in yellow in each of the two tables.
The obvious conclusion is that the better stocks did during this period, the less it was worth worrying about the changing proportions of the portfolio. It is worth noting that at the end of year 3 the ratio was not 50/50 but 61/39. With rising equity markets our portfolio with the initial 50/50 ratio can quite quickly become 60/40 and then 70/30, only that rebalancing comes in handy not when things are going well but when things are going badly. So what did the performance of the portfolio with rebalancing look like and in which years did it outperform the one without the rebalanced component ratios? You can find the answer in the table below:
It is not surprising that, again, the portfolio with annual rebalancing won over the portfolio without such a mechanism mainly in years when the stock markets were down. The great advantage of the rebalanced portfolio is that in good years for the stock markets it moves a large part of the funds to the bond market, which provide the portfolio with a slow but steady growth, coming in handy mainly when the markets get bad.
As soon as markets bounce back, the rebalancing portfolio starts to lose, reminding investors why momentum-type anomalies work. It’s worth recalling that the tables above are for a non-existent stock market whose annual returns I made up for the sake of the example. Another important conclusion is that in both examples, the returns of the two portfolios were very close to each other, which in the long run would certainly “diverge”. Now let’s discuss in what situations it is worthwhile to perform portfolio ratio rebalancing.
When is it worthwhile and when is it not worthwhile to rebalance the proportions?
In portfolio ratio rebalancing, consider the following questions:
Is it worth it to balance an investment portfolio’s proportions? I would say yes, especially as its value increases. I can’t imagine a portfolio worth a million zloty or more whose components would not be rebalanced. Rebalancing is to make sure that the portfolio returns to its predetermined proportions and is therefore “tailored” to our risk tolerance.
When is it appropriate to perform portfolio rebalancing? I would say that we have three very different ways of doing it, and it is worth choosing the one that is easiest for us to carry out:
- Every X months, regardless of the deviation.
- Every X months, but only when the deviation exceeds Y%.
- Only when the deviation exceeds Y%.
A hybrid option is also possible:
Every X months, but only when the bond share exceeds the set share for stocks (i.e., when stocks go down). I call it “rebalancing from below” and I will present it right now with an example.
Or no rebalancing at all:
Never (only at the beginning, e.g. making large purchases).
Although I feel that I have only “licked” the topic of portfolio rebalancing, I think I managed to give you some interesting ideas on alternative/non-standard ways of rebalancing. The point of this post was to make you aware that, just like the shape of the portfolio itself, it is also worth having a specific plan to follow when rebalancing. Its simplest variant is rebalancing with new deposits, which usually ceases to be possible at a certain portfolio size (usually around PLN 1 million, but it depends on your monthly savings).
At the same time I wanted to prove that rebalancing often brings unexpected, random and chaotic results, so it would be extremely difficult to determine the optimal method of its implementation, which will always maximize our rate of return on investment. Just as in life, there are no shortcuts in investing, so each of us will have to do our homework when deciding on a specific way to rebalance our portfolio proportions or not.