Shrinking The Gap, Part 4- Rebalancing

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

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.