Portfolio Rebalancing – Why should you do it?
Diversification is a well supported investment strategy. Virtually all professional investors use it. The key is not having all your eggs in one basket.
According to Noble Prize winning research - Modern Portfolio Theory, diversification help investors make higher risk adjusted returns. I have talked about how diversification works when you add bonds to a share portfolio before.
Determining how much money to invest in each asset class (i.e. Australian shares, global shares, bonds) is called Asset Allocation. 90% of your returns come from asset allocation, not picking stocks.
Does that mean once you pick you initial asset allocation, you can basically forget it, leave it untouched, forever?
Well ... actually, no.
We are strong supporters of passive investing. Doing less is more (returns). But you should think about portfolio rebalancing.
So then, what is portfolio rebalancing? And why is it important?
What is portfolio rebalancing?
Suppose you have a $10,000 investment portfolio. You decide that the best asset allocation would be 50% shares and 50% bonds.
What would happen if you leave it untouched for 10 year?
If you did that between Aug 2005 - Aug 2015, your money would have nearly doubled to $19,232. Your shares would be worth $9,392 (48.8% of your portfolio). Bonds would be worth $9,840 (51.2% of your portfolio).
Whilst this seems pretty stable, it is definitely not the case if you look back through the years. During that period, shares were quite volatile. In it's best year of 2007, it increased by 27%, but the worst year in 2008 saw it drop 14%. Whilst bonds also performed in the range of 4.2% to 10.7% return per year.
When shares did well, bonds didn't do so well. The negative correlation between the two made the portfolio drift away from the target allocation of 50:50.
For example, between 2007 and mid 2008, the shares component was almost 60% of the portfolio. But in Jan 2009, Bonds was almost 60% of the portfolio after the GFC hit.
The time to rebalance is when the asset allocation drifts from the target allocation. You sell the asset that is over-weighted and use the money to buy the asset that is under-weighted. Taking the portfolio back to 50:50.
Why Rebalance a Portfolio?
There are two main reasons for portfolio rebalancing:
- keep the portfolio's risk profile to your target levels;
- increase returns by selling high and buying low.
Maintain Target Risk Level (preventing drift)
When there is portfolio drift, the portfolio's risk profile gets out of whack. In our example, when shares get to 60%, the portfolio is carrying way too much risky (growth) assets.
Most professionals suggest that 5% drift is worthy of a rebalancing event. In our case, that means when shares grow to more than 55% or less than 45% of the portfolio value.
In the 10 years to Aug 2015, shares had more than 5% drift on 25% of the trading days. So by doing nothing, the portfolio was taking on too much risk, or too little risk, 25% of the time.
Inherent in the process of rebalancing is the discipline to buy low and sell high. The key ingredient in successful investing.
The logic here is pretty simple. Shares drift higher after a strong period of performance by the sharemarket. When it reached 60% of the portfolio in mid-2008, the sharemarket had jumped by 20% in 2006 and 27% in 2007. Similarly, when shares drift lower, it is due to a period of poor sharemarket performance.
If you were to rebalance the portfolio in Oct 2007, you would be selling shares when they are reaching high points, and buying bonds when they were unloved.
Many studies have shown that rebalancing can provide an extra 0.3% to 0.5% return per annum. Over 10 years, this is an extra 3% to 5% return on the investment portfolio.
How to rebalance a portfolio?
There are tonnes of methods to rebalance a portfolio. The key decision points in deciding when or how to rebalance are:
- frequency of "looks" - how often do you look at the portfolio and measure the asset allocation vs the target allocation;
- flex range - how strict will you be in keeping the asset allocation exactly the same as the target allocation. For example, 5% range is considered appropriate by industry experts. That is allowing shares to be 45% to 55% of the portfolio in our example;
- rebalance range - once decided to rebalance, how much do you rebalance by? Do you rebalance back to the target allocation (say 50%) or allow for some drift (say rebalancing from 58% back to 53%)
Some popular methods of rebalancing are:
- Look at portfolio asset allocation once a year. Rebalance the assets back to their target allocation;
- Look at portfolio allocation every quarter. Rebalance the assets only if they have drifted more than 5% from their target allocation. Rebalance the assets back to their target allocation.
In this post, we look through different methods of portfolio rebalancing. We compare the increased returns and risk reduction benefits of different methods.