Finance 101: Rebalancing

Let’s talk rebalancing the portfolio.

Most personal finance websites/books/etc. focus a great deal on trade entry; less on trade exit; and usually even less on ongoing maintenance/rebalancing.  Compared with finding ‘the next Google’ or ‘signs to move to cash’, the monthly/yearly rebalance seems pretty boring.  However, rebalancing is very important to a long-only portfolio performance.

Broadly: a long-only portfolio comprising some mix of assets will, over time, become dominated by the best-performing asset.  The usual example is: a mix of equity/bonds will become more and more invested in equities, given their outperformance long-term.  If you don’t rebalance, you are implicitly creating a momentum portfolio – more investment in winners than losers.  While this may have some merit as an idea (I like momentum), the diversification of the portfolio goes into the toilet.  The portfolio becomes a one-way bet on equities.

Harking back to the CFA curriculum, there are a few broad categories of rebalancing:

  1. Constant mix – the boilerplate, constant proportions of (say) 60% equities and 40% bonds.
  2. Buy-and-hold – the set and forget approach.  Buy on day 1, then never rebalance.  What I’m warning about above.
  3. Constant Proportion Portfolio Insurance (CPPI) – Somewhat the opposite of constant mix, this is a fairly explicit momentum strategy.  Equities get an even larger allocation than buy-and-hold as stocks rise.  The kicker is this: CPPI trades off between a ‘risky’ asset (either 100% equities, or maybe a 60/40 portfolio??) and a ‘riskless’ asset (e.g. cash or T-bills).  So the idea is that you put on more risk as risky markets perform well.

When do you rebalance?

  1. Time-based – probably the most common approach.  Every month/quarter/year you look at your statement, then rebalance to your target allocation.  For #1 above, you go back to the original 60/40 split (or whichever mix you’ve chosen).  For #3, you use a formula outlined in places like this.
  2. Error-based – for those keeping closer attention to the markets: rebalance back to target whenever the realised allocations stray beyond a certain tolerance.

There have been a multitude of research papers written about when is best to rebalance. The trade-off is pretty simple: how much trading cost is incurred, versus the drag induced by not having ‘optimal’ allocations.  From what I’ve read, my opinion is the following:

  • Rebalancing is absolutely necessary.  Buy and hold is consistently beaten by rebalanced portfolios.
  • However, rebalancing need not be too frequent.  I’ve read the best results from rebalancing no more than quarterly, when holding an all-securities portfolio (NB: if you’re using options, a monthly rebalance is worth the effort).  Annual rebalances are a good rule-of-thumb.

Finally, let’s look at a (somewhat) practical example.  I’ve taken total return series for the S&P 500 and US 10-Year Treasury Notes, from 1998 until end-Oct 2014 (Source: Quandl).  Starting with a 60% S&P and 40% Treasuries, I’ve created 3 portfolios:

Screen Shot 2014-11-03 at 15.36.33

  1. Buy-and-hold – initial purchase of stocks and bonds remains unchanged throughout the time period.
  2. Constant mix – portfolio is rebalanced to 60/40 at the end of each month.  Notice that, over this period, the constant mix slightly outperformed buy-and-hold, despite equities outperforming bonds handily in the period.  We must be capturing some mean-reversion among the two asset classes.
  3. CPPI – the portfolio is rebalanced according to the following parameters: multiplier of 3; cushion value (Treasuries used as cushion) of 80.  Rebalance occurs at each month-end.  Notice that this is a much more aggressive rebalancing technique than the others; due to the equity outperformance, especially in the past few years, this ends up being the best relative performer (albeit with much higher volatility).

Which method do you prefer?


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