In my column last month, I started a discussion about rebalancing, noting that virtually every study about the sustainability of withdrawals from a portfolio has some rebalancing assumption imbedded within it. I focused on the importance of buying when markets are down and the difficulty practitioners often encounter in getting clients to take such action. Further, I showed fears of making things worse by being "early" when one rebalances may be overblown. Today I hope to show that promises of outsized additional return may be exaggerated as well.
The basic scenario consisted of a portfolio that targets a 50/50 split between A and B with $100,000 in each. A earns 4% while B loses 20%. The total is $184,000 (A=$104,000 and B=$80,000). To rebalance, $12,000 is moved from A to B so each has $92,000. If A again rises 4%, it will be worth $95,680. The portfolio will be back to $200,000 when B rises 13.39% ($104,320-92000/92,000). At that breakeven point, the actual price of B would still be off by 9.29%. If no rebalancing had occurred, A would be worth $108,160 and B would have had to add 14.80% to get the portfolio back to $200,000 (91,840-80,000/80,000).
In the scenario above, there is no indication of the time in between transactions. This has no bearing on the premise that buying when down can get the portfolio closer to whole faster than if no buy occurs even if there is more to the downside.
For simplicity, assume A earns nothing but B ultimately drops 40% from its start point. Rebalancing when we did (after a 20% decline) would result in a lower portfolio value than if no rebalancing occurred, but not much. In this case, just $2,500 ($157,500 vs. $160,000). The difference between rebalancing and not rebalancing is only the $10,000 buy after the 20% drop in B.
If you hadn't rebalanced at -20% but did at -40%, B would need to increase by 50% to get to whole if the only rebalancing happened at -40%. If rebalancing had occurred at the -20% point and again at -40%, B would need to increase by 54%. Either rebalancing choice requires less of a bounce than the 66.67% required with no rebalancing at all.
Clients that want their portfolio managed over the long-term will be faced with a never-ending series of chaotic changes in the value of their holdings. Looking beyond this isolated sequence illustrates other issues.
Bear markets occur on average every five years. When markets go lower, we are more inclined to be buying. When does inclination turn to action? Does rebalancing really add to portfolio returns?
A number of studies over the years have indicated that rebalancing adds to returns in any periods and that there is no big difference between doing so quarterly, semi-annually or annually, in cost-free environments. In practice, particularly in taxable accounts, it makes little sense to incur costs associated with making trades simply for the sake of trading. Instead many practitioners use their judgment to override the calendar's prompt.
For instance, if we start with $100,000 each in A and B and when we get our prompt from the calendar, A=$100,000 and B=$103,000. Most would agree with the portfolio only up 1.5% and an A to B ratio of 50.74% to 49.26%, the situation does not beg for action.
Gobind Daryanani's 2008 Journal of Financial Planning contribution, "Opportunistic Rebalancing: A New Paradigm for Wealth Managers" provided a view of what varying thresholds yielded in the way of return enhancement. Daryanani established bands around each asset class within which the asset class could fluctuate without prompting a trade. For instance, if a target allocation to an asset class was 10% and a 20% band was set, that asset class could comprise between eight and 12% of the portfolio and no rebalancing would be indicated.