For investors, the $1 million question is, "Why don't all of us rebalance?" according to Jason Hsu, chief investment officer at Newport Beach, Calif.-based Research Affiliates.
In Research Affiliates' July newsletter Hsu says research shows the long-term benefit of rebalancing, yet anecdotal evidence suggests that most investors don't rebalance their portfolios -- that is, buy assets that have become cheap and sell assets that have become expensive. In fact, many investors do the exact opposite.
The reason it's so hard for investors to rebalance, says Hsu, is less about "behavioral mistakes" and more about "the fact that 'rational' individuals care more about other things than simply maximizing investment returns. Perfectly rational individuals exhibit changing risk aversion that makes it hard for them to rebalance into high-return assets that have had steep price declines," he says. "An unwillingness to buy low and sell high is not characteristic of just retail investors unaware of the finance literature and market history, but also sophisticated institutional investors advised by investment consultants and academics who are also prone to the same behavior."
Hsu says financial research shows that asset classes exhibit long-horizon price mean-reversion. So when an asset class falls in price, resulting in a more attractive valuation level relative to history, it's more likely to experience high subsequent returns. For example, when the S&P 500 Index falls in price, its dividend yield increases; empirically the subsequent five-year return on the S&P 500 tends to be significantly above average.
Similarly, when corporate bond prices fall as credit spreads blow out, the forward return on corporate bonds increases, says Hsu. Price mean-reversion in asset returns suggests that a disciplined rebalancing approach in asset allocation that responds to changing valuation levels would improve portfolio returns in the long-run.
So, if "buy low and sell high" works so well, why don't investors rebalance? Hsu asks. He says research suggests that investors become more risk averse and unwilling to add risk to their portfolios despite lower prices when their portfolio wealth declines. Investors tend to become more risk seeking and, therefore, more willing to speculate even at high prices when their portfolio wealth increases.
In bear markets when personal income and wealth is declining, any further loss in portfolio value could reduce the household's quality of life and retirement planning, he says. Investors become more risk adverse and unlikely to want to take on more investment risk, even when assets are attractively priced, he adds
If the $1 million question is "Why don't investors rebalance?" Hsu adds, then the $5 million question is "Should you rebalance?" Statistically, he says you're likely to outperform in the long run if you rebalance in response to major price movements. However, when you buy risky assets during economic distress, Hsu says, there's a strong chance your portfolio may post a greater decline than if you didn't rebalance. "In the short run, your probability of being fired as a fiduciary, of being blamed by clients you advise, and, most importantly, of marital strife, become moderately higher when you rebalance," Hsu says
In spite of the benefits of rebalancing, humans' changing risk aversion makes them poor stewards for managing long-term returns, he concludes.