It is good to see share prices back up, with the S&P 500 and NZX 50 at new highs. We do expect more volatility moving forward, with uncertainty surrounding the upcoming elections, COVID-19 and economic concerns.

With prices going up and down, you may find your portfolio drifting away from the allocations you originally chose. During times like these, we may have to rebalance more often.

This week, we wanted to shed some light on how rebalancing works, why we do it and the policies we use to make the most of it.

What is rebalancing?

Rebalancing is the process of buying and selling investments to bring your portfolio back to target.

For example, say you started with a portfolio with $100, invested half in shares and half in bonds. If the bonds didn't change in value (staying at $50) while the shares doubled in value (went up to $100), your portfolio would be invested 2/3s in shares, 1/3 in bonds.

While this would have been the result of very strong returns from shares, the risk of the portfolio has gone up considerably. To bring the portfolio back to 50:50, rebalancing would involve selling $25 worth of shares and buying $25 worth of bonds.

Portfolio drift

Rebalancing is necessary due to this drifting away from target. This tends to happen over a long period of time, with a portfolio that is never rebalancing slowing approaching a nearly 100% allocation to shares.

Looking at the performance of the S&P 500 and US Long-term Corporate Bonds, in USD since 1926, we can see how this plays out. We will ignore taxes and costs for simplicity's sake.

What would happen if we invested $100 as above, split 50:50 between shares and bonds? Over more more than 94 years, the $50 of bonds would have grown to $15,553. The shares would have grown to $472,867(!) and your portfolio is now allocated nearly 97% to shares.

Taking the average returns for these two investments, after 10 years you should expect your 50:50 portfolio to turn into a 60:40. During periods of volatile returns however, this can happen very quickly.

In the graph above, you can see the spike in share returns around 1932. If you had a 50:50 portfolio in July 1932, 12 months later it would be invested 70% in shares! Assuming there was good reason for your target allocation, it would be sensible to sell some shares and buy some bonds. 

What to consider when rebalancing

The three most important considerations are the same as with investing in general; risk, returns and costs. When you decide to rebalance should be based on balancing all three.

As shown above, not rebalancing leads to more risk and higher returns. But rebalancing too frequently can lead to a poor outcome, as the cost of trading eats into returns.

We should consider the risk of the portfolio before deciding to rebalance. If it has drifted far from the amount of risk we deem acceptable, then rebalancing is sensible.

Most good policies will define the range which is acceptable. For example, we could allow our 50:50 portfolio to become a 55:45 before we do anything.

Costs are associated with trading for even the most liquid investments, so this must also be considered. It can be difficult to weigh trading costs against an abstract concept like risk. 

Can rebalancing provide higher returns?

Through rebalancing, you will be regularly selling high and buying low. Many believe this leads to a "rebalancing premium", although this comes with the assumption that good returns are followed by bad returns and vice versa.

Two sources of research which have guided our own policies are Vanguard's Best Practices for Portfolio Rebalancing and Marleena Lee from Dimensional's Rebalancing and Returns. They share the same conclusions regarding returns. From the Vanguard paper:

“Vanguard research has found that there is no optimal frequency or threshold for rebalancing, since risk-adjusted returns do not differ meaningfully from one rebalancing strategy to another.”

The problem for investors in chasing a rebalancing premium is the difficulty in choosing the right strategy to capture it. Some may have outperformed over some historic period, but none consistently. From Marlena Lee's paper:

"One must be cautious when interpreting reported benefits of rebalancing strategies that are formulated using historical returns because noise in realized returns will make certain strategies look good over certain periods, especially if researchers try hard enough to find good results.

How confident should one be that this strategy will continue to be the best performer in all periods and for all allocations? There are multitudes of trading rules that work well in the historical data from which they were mined but fail to continue their performance out of sample. It is unlikely that rebalancing rules are any exception."

These conclusions are actually quite useful for investors, as we can shift our focus to managing risk and costs.

Our rebalancing policy

In order to balance risks and costs, our rebalancing policy is based upon the following practices:

• We set a tolerance for how far each investment asset can drift from target, currently 10%. This means an investment making up 50% of your portfolio can drift between 45% and 55% without necessitating a purchase or sale.

• When rebalancing, we purchase/sell assets in order to bring allocations to the edge of tolerance, instead of back to target. If the asset above drifted to 57%, we would sell enough to bring this back to 55%.

• Whenever there is an excess of cash, we will use this to purchase underweight assets.

• We check portfolios are within tolerance once each week.

• When quarterly distributions are paid out, we use these funds to purchase underweight assets.

This policy aims to reduce unnecessary trading while managing portfolio risk.