Rebalancing is widely recognized as a fundamental tool for portfolio management, but it's still underappreciated. In fact, a fair amount of what's considered alpha-beating a conventionally designed benchmark-is simply returning assets to target weights.

That's hardly a secret, but it's easily overlooked. Yet even for those who focus on this portfolio tool, rebalancing is wide open to interpretation.

"I started calling [rebalancing results] behavioral alpha a couple of years ago," says Carl Richards, a financial planner who runs Prasada Capital Management. Routine rebalancing limits risk exposures, so it's a strategy for preventing large mistakes, he explains. But a number of studies suggest that rebalancing can modestly boost performance as well.

That also means it can stunt performance at times. Rebalancing a stock/bond portfolio in the second half of the 1990s, when equities were on a tear, would have crimped an investor's potential returns, for instance.

The prospects for rebalancing are quite a bit brighter over a couple of business cycles. But why should we expect rebalancing to add value (higher return, lower risk or both) at all? The simple answer is that markets don't move in a straight line.
Rebalancing exploits market cycles, which are a hardy perennial. Yet many investors don't have the discipline to take advantage of the fluctuations. And paradoxically, that behavioral bias can also explain why rebalancing helps those who do have the discipline.

A trio of finance professors suggests in a recent report that part of the return premium from rebalancing stems from the fact that most investors aren't doing it in a timely manner after substantial price changes in the capital markets.

"There is a large group of households that invest in equities but only change their portfolio shares infrequently, even after large common shocks to asset returns," write the professors, YiLi Chien of Purdue, Harold Cole of the University of Pennsylvania and Hanno Lustig of UCLA, in their study, Is the Volatility of the Market Price of Risk Due to Intermittent Portfolio Rebalancing?

This is another way of saying that the equity risk premium bounces around a lot because so many investors fail to take advantage of the volatility. As Professor Lustig told me recently, "The failure of passive investors to rebalance forces active investors to absorb more risk." That higher risk for rebalancers-the risk that prices will move dramatically-translates into higher return ... usually.

The reluctance of investors to rebalance (or rebalance quickly) when the opportunities look brightest isn't surprising. Few investors were buying stocks after prices cratered in late 2008/early 2009. Those who did likely saw better trailing portfolio returns than those investors who waited or moved to cash.

Opportunistically adjusting the portfolio mix offers rich potential, yet relatively few investors have the fortitude to act decisively. A 2004 study of 2,000 participants in TIAA-CREF retirement plans found that nearly three-quarters of them had made no changes to asset allocation during the decade through 1999. The vast majority of the households made few if any adjustments to allocations, concluded John Ameriks of Vanguard and Stephen Zeldes, a professor at Columbia University's Graduate School of Business, in their report, How Do Household Portfolio Shares Vary With Age?

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