The Importance of Rebalancing your Portfolio

by Wayne Ferbert on July 16th, 2013

We write on this blog regularly about re-balancing your portfolio. In our book, we recommend an asset allocation strategy – and if you structure an asset allocation approach to your portfolio, then you must commit to some re-balancing tactic.
 
We like to re-balance once per year. But we also look to re-balance when an asset class significantly under-performs or over-performs. We look for these chances when the performance deviation is so large that is causes at least one asset class to be more than 5 percentage points away from its target allocation of the overall portfolio.
 
The current market highs in US equities coupled with the depressed state in International equities creates a likely divergence in allocation for many Buy & Hedge investors – so consider this opportunity now.
 
This opportunity made me wonder what an annual asset class re-balance would have done to a portfolio in the last 10 years. So, I pulled down the JP Morgan Asset Management summary of Asset Class Performance for the last decade. You can see it below.
 

If you re-balance at the end of every year starting with an equal weight portfolio in 2003, you would end up with a portfolio that only marginally out-performed an equal weight portfolio that never re-balanced. The return improvement over the last decade would have only been about 3.5% - or about 0.35% per annum.
 
Those kind of returns don’t really inspire you to take the time to rebalance every year. But this example is equal weight because we are trying to make a point: Even if you put no thought in to your asset allocation approach by percentages, if you were committed to it, you would have still out-performed.
 
However, if you only isolated the performance since the end of 2007 (ie, prior to the market corrections from the credit crisis), the performance deviation is a little more significant for being just a 5 year window. The returns of the equal weight portfolio that was rebalanced annually since the end of 2007 to now would have been +14.9%. Meanwhile, an equal weight portfolio that was not re-balanced over the same time period would have produced a +10.2% return.
 
The difference of 4.7% over 5 years is a little more meaningful to your portfolio return in this case.
 
Why the deviation when you look at 5 years versus the 10 year window? Because the last 5 years had a correction of significant proportion – and the re-balancing drove money to the under-performing assets when they traded at under-performing levels.
 
Meanwhile, the first 5 years of the 10 years window had the same asset classes as the best performers for 5 straight years. The two International equity asset classes were in the top 3 performer groups all 5 years. So, if you re-balanced, you ended up selling profits in those categories and re-investing it in categories that didn’t perform as well as those international categories.
 
Is this a rare event? No. Does it happen a lot? Not at all. So, do you need to consider this kind of consequence when looking at re-balancing? Not really. These best performing International sectors are also among the most volatile sectors in a portfolio. So, you wouldn’t likely be equal weight in them anyway. While it would have been nice to look back and be over-weight the best performing sectors from 2003 to 2007 – these were the worst performers since 2008. Hence the volatile nature of International markets.
 
This is why we re-balance. We can’t predict the best performers – but a structured program for selling the best performers and re-investing in the worst performers has created excess portfolio returns for the better part of the past 50 years in the markets.
 
It should make sense to you – it is a methodical way to sell high and buy low. Make sure you are implementing it. Especially now while two of the most important asset classes have diverged in performance by so much.
 


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