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Portfolio Rebalancing: Is it worth it?

Portfolio rebalancing: Is it worth it?

By Scott Francis
September 3, 2010

PORTFOLIO POINT: Bringing asset quotas back to target allocations can reduce volatility and help you sleep a lot easier.

Several weeks ago I looked the overall impact of asset allocation on a portfolio before concluding that holding extra cash did not significantly reduce portfolio returns (see Would it kill you to own fewer shares?).

Another strategy that deserves some serious consideration is the idea of portfolio rebalancing. This essentially involves investors committing to a target investment asset allocation and then buying and selling assets over time to maintain that allocation.

Studies show that not only does this enhance portfolio returns slightly, but also reduces their volatility.

On a practical level, that can be illustrated by considering the case of the investor who has a preferred portfolio design of 50% in growth assets (let’s say Australian shares) and 50% in defensive assets (say cash, deposits and bonds).

During periods of strong investment returns, the investor is faced with a portfolio that now has a 60% allocation to equities and a 40% allocation to cash. Rebalancing involves selling down some of the strong-performing equities to restore the target allocation of 50%.

The next step is to let us consider a period of time where growth assets fall sharply in value. The portfolio might now be 40% growth assets and 60% in defensive assets. Bringing the portfolio back to a 50:50 split means using some defensive assets to buy more growth assets.

Importantly, the key strength of this system ensure that the investor “buys low and sells high”, which should be the aim of every investor.

It is worth thinking about the great opportunities to purchase growth assets in the past – in the downturn of the early 1970s, the 1982 recession and after the 1987 stockmarket crash. Having a system that would have allowed you to buy growth assets at these times would have been useful in creating long-term wealth. A disciplined approach to portfolio balancing would have seen an investor purchasing growth assets at these low points, just as they would have when markets traded at less than 3300 points back in March 2009.

The next question is: Does this strategy work?

I haven’t seen a huge number of studies that look at Australian results, but a US study by Weinstein, Tsai and Laurie over the period 1980 to 2002 (see The Importance of Portfolio Rebalancing in Volatile Markets) showed that an investor who did not rebalance their portfolio annually ended up with a return over the period of 10.8% a year; those who did rebalance ended up with 10.9%.

As well as the marginally higher return, the rebalanced portfolio produced less volatility. For example, the lowest annual return of the rebalanced portfolio was –8.3%, while the lowest annual return when there was no rebalancing was –14.4%.

Another measure of volatility is the standard deviation of returns; the higher the standard deviation of returns the less the portfolio volatility. The standard deviation of returns for the rebalanced portfolio was 11.3% a year, while the non-rebalanced portfolio had a higher standard deviation of returns of 12.9%.

What’s even more fascinating is that when we apply this theory to the Australian market the results are more or less identical.

If we assume a portfolio of $100,000 with a 50% allocation to cash (in this instance the UBS Australian Bank Bill Accumulation Index) and a 50% allocation to equities (in this instance the ASX 300 Accumulation Index) over a period of 12 years that portfolio will grow to $223,800.

If that portfolio were to be rebalanced on an annual basis (by rebalancing only every 12 months, we benefit from the 50% CGT exemption) so that the target allocations of 50% cash and 50% equities were maintained then the portfolio grows in value to $229,300 or an additional $5500.

This is not a huge sum of money, although I would always choose to have an extra $5500 than not. The real value of this strategy comes from the enhanced “sleep at night” quotient.

-Balancing vs non-balancing
Average annual return
Standard deviation of returns
Biggest annual
portfolio loss (year
to June 2008)
Portfolio with no rebalancing
Portfolio with rebalancing

The average annual return with rebalancing is slightly higher, and the “standard deviation of returns” is slightly lower. This shows that the portfolio that is rebalanced annually is less volatile, it has less extreme ups and downs. In the worse year that we look at, the portfolio where there is no rebalancing lost an additional $8390 in value.

Another question Eureka Report readers might be considering is: How might this strategy impact a portfolio held that is at the point of paying a pension?

Assuming that a pension is paid out of the cash investments of the portfolio, and the dividends/rent received from growth assets, it makes sense to keep the portfolio at around the target asset allocation.

It remains important to sell some growth assets after periods of good returns and, after a downturn, to make sure that there is sufficient exposure to growth assets to counter the long-term impacts of inflation.

SMSFs in pension phase are likely to have a smaller allocation to risk assets, which may ultimately make it easily to stay disciplined when it comes to giving up equity market gains.

There is evidence that investors generally do a poor job of market timing decisions. A study done by American financial services firm Dalbar shows that over long periods investors tend to buy and sell at exactly the wrong times, and reduce their returns to well under the average market return.

Legendary investor Warren Buffett famously encourages investors to “be greedy when others are fearful, and only be fearful when others are greedy”. A disciplined approach to rebalancing allows you follow this advice: buying when markets are down (fear) and selling when they are high (greed).

Being disciplined with this strategy is easy; buying shares in March last year, after the record loss by AIG pushed the ASX 200 below the 3200 mark, was perhaps one of the most counter-intuitive investment decisions many people would have made.

The reality, however, is that this has proven to be a highly profitable time to invest.