Periodically rebalancing portfolios is often thought of as a practice of risk control, but it can also provide value to the long-term returns of your asset mix. Investment returns of various asset classes tend to be highly cyclical and the process of rebalancing will naturally reduce the exposure to those that have recently outperformed and add to the various asset classes that have underperformed; which is what can be additive to long-term returns. (1)
Rebalancing is a portfolio management strategy that refers to the act of trading in the investor’s account to return the investor’s portfolio asset allocation back to its original targeted allocation.
For instance, an investor may have a long-term strategic allocation of their portfolio of (60/40), with 60% allocated to equity funds and 40% allocated to fixed income funds; all with the intention of giving them the best probability of achieving the long-term rate of return required to achieve their cherished financial goals while taking on the least amount of risk in doing so.
After the investor’s initial allocation is implemented, market fluctuations in both stocks and bonds will drive the portfolio’s allocation to each respective asset class to diverge from the targeted mix. As an example, when stocks are having a strong performance year it can lead to the equity portion of the client’s portfolio increasing to a level greater than the targeted 60%. This deviation from the target is sometimes known as an “overweight”, and if ignored for an extended period can result in the client’s portfolio taking on an entirely different risk/reward profile than originally intended.
By identifying a fixed periodic time frame for performing rebalancing, the potential expansive deviation from your target portfolio allocation can be avoided without the speculative practice of “market timing.” Your portfolio will simply trim the positions that have outperformed and add to those that have underperformed over the trailing period. This is an effective method of risk management and has several potential benefits.
Using the same asset allocation as previously mentioned, 60% equities and 40% fixed income, the following information will serve as a simple illustration of how annual rebalancing can increase portfolio returns long-term.
The following example will use trailing data from the S&P 500 to represent equity returns and the U.S. Barclay Aggregate Bond Index to represent fixed income returns. Annual rebalancing will mean that the client’s portfolio will start each calendar year with the targeted asset mix of (60/40), with trades being made at year-end to return the account back to this target. The following illustration is proof over nearly a trailing two-decade period in recent history of how this simplistic portfolio management strategy can produce impressive results:
The results, as outlined by this simple example, portray a powerful message. A portfolio with an asset mix of (60/40), rebalanced annually, provided a higher cumulative and annualized rate of return than an all equity or all fixed income index over nearly twenty years. (2)
The emphasis here is that rebalancing works. This may sound like a logical approach to managing a portfolio, but many times it is overlooked and not executed by investors. Having a consistent rebalancing process is critical to capturing the additive value potential that is available. Rebalancing is one of many methods to add value when managing a portfolio; and while you may not be able to control where markets are going in the short-term, you can always plan and control how you react to their movement. (2)
Waterford Advisors, LLC’s financial planners are always available to answer any specific questions that you may have. Please feel free to contact our office at any time.
Sources: (1) Arnott, Amy C. “Why Rebalancing (Almost Always) Pays Off.” Morningstar, Inc., 6 July 2020, www.morningstar.com/articles/990564/why-rebalancing-almost-always-pays-off (2) Swinsburg, Brad. “A Deeper Dive: Return Potential of Rebalancing.” Smith & Howard Wealth Management, 1 Aug. 2019, www.smithhowardwealth.com/a-deeper-dive-the-return-potential-of-rebalancing-first-quarter-2019/