We continue in our series of "Shrinking The Gap". Today we are going to cover the value added disciplined of rebalancing. Anyone that has an interest in investing has heard the term rebalancing- the act of bringing a portfolio back to its target weighting in various asset classes. It typically involves selling the asset classes that have gone up in value and adding to asset classes that have shrunk. In this way, it is a systematic way to buy low and sell high. But like many elements of investing it is important to note that it doesn't always work. In a prior post we talked about the benefits of diversification. Over time, this strategy tends to be beneficial, but there are certainly periods, like the last five years, where it hasn't paid to diversify (US stocks have handily outperformed almost all asset classes). In the same vein, rebalancing may not work for periods of time. In many ways it can be increasingly frustrating. I have illustrated a time period to show how challenging it can be. Below are the returns of two portfolios* from the 1990s (12/1989 to 12/1999):
- 60% US Stocks/40% US bonds (rebalanced quarterly)- 13.90% annual return
- 60% US Stocks/40% US Bonds (never rebalanced)- 17.82% annual return
For those keeping score at home, that is nearly a 4% higher annualized return by doing nothing over that 10 year period. If you had $1 million invested you'd have approximately $1.5 million more BY NOT REBALANCING! So, is this really a good strategy to pursue?
We think the answer is unequivocally yes. The main value of rebalancing is not to increase your return, but to control your risk. During periods of expansion in the stock market, you will find that you are taking money from the most risky assets each year and adding to safe assets. During periods of contraction, portfolio rebalancing causes you to add to risky areas of the portfolio periodically. It is during these periods of contraction where most investors get tripped up. They either do nothing, or worse, get scared and sell at inopportune times (the bottom). Rebalancing during these periods of growth and contraction is a risk management tool. It may not work during periods when a certain asset class explodes, but it smooths out returns over longer periods of time. We have done research to show how rebalancing (60/40 portfolio) during a bear market (and subsequent recovery) can add both return and risk to a portfolio at a time when most investors are questioning whether to stay invested at all (click to make bigger):
Rebalancing takes a degree of discipline that can make even the most committed investor squirm. The act of selling something that is doing well and adding to asset classes that seem to have no hope just goes against our wiring. That is why so few do it, and why so few get the benefits of this simple act.
*US Stocks are represented by CRSP 1-10 Index, US Bonds are represented by 5 Year Treasury Bonds
As we continue in our series on "Shrinking The Gap", we are going to focus on another positive contributor to performance: exposure to risk factors. Extensive research has been performed to determine what specific factors have a meaningful impact on both risk and return. For purposes of this post, we are going to focus on the two that we believe are the most persistent:
- Size factor- small companies outperform large companies
- Value factor- value companies outperform growth companies
In 1992, Nobel prize winner Gene Fama and Ken French release groundbreaking research on this topic. Their findings were significant and have sparked an entire industry of "factor investing" or "smart beta" strategies. The firm best embracing this concept (and finding the most success) has been Dimensional Fund Advisors. A chart of the Fama/French research can be found below:
What their research has proved is that small companies and value companies have generated BOTH higher returns and higher risk for investors. This is true not only in the US, but in other free market economies they were able to obtain data from. So what does this mean for investors? First, those who are willing to accept elevated risk levels are able to generate higher returns by tilting their portfolios towards these factors. This is one way an investor can "close the gap" between their actual return and the market's return. Second, rather than focusing things that don't matter (which fund is going to outperform, is the market high, which stock should I buy), investors now can concentrate their efforts on factors that will have a real impact on their portfolio's performance.
We are continuing in our series on "Shrinking The Gap". The "Gap" refers to the difference between the market's return and what investors actually return in their portfolio. In our first post we discussed the six factors that either positively or negatively impact this gap:
- Portfolio Construction
- Risk Factors
In this post we are going to touch on the first positive contributor: portfolio construction. There are countless studies that show how much of an impact portfolio construction has on risk and return. In the study "Determinants of Portfolio Performance" researchers determined that over 90% of the variations in a portfolio's return is the result of the asset allocation. Factors such as market timing or security selection had almost no impact on returns. Not because these elements are not important, but because no one has been able to consistently demonstrate skill in these areas. Portfolio construction is mainly focused on how a portfolio should be allocated. It is often said that diversification is the only free lunch when investing. Below is a good example of why this is the case:
Most people believe that you have to take more risk to get a higher return. This is not always the case. By constructing a portfolio consisting of non-correlated assets you can find ways to increase your return without taking on significant more risk. Diversifying out of an entire large cap stock portfolio into more of a global market portfolio, you can see that returns were more than 2% higher per year with almost identical volatility (standard deviation). In addition, the worst 10 year period shows that the global market portfolio was able to avoid the losses that are inevitably found by concentrating your assets in one area.
Having an appropriate allocation for your risk and return requirements is essential for how you manage your assets. The above example shows that by constructing a diversified portfolio, you have a much higher probability to "shrink the gap".
Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.