Research Affiliates: Rebalance Or Rush Hour?

Key Points

• Systematic rebalancing raises the likelihood of improving long-term risk-adjusted investment returns.
• The benefits of rebalancing result from opportunistically capitalizing on human behavioral tendencies and long-horizon mean reversion in asset class prices.
• Investors who “institutionalize contrarian investment behavior” by relying on a systematic rebalancing approach increase their odds of reaping the reward of rebalancing.

Introduction
Embracing a disciplined approach to rebalancing can lead to better long-term investment outcomes. Overcoming the natural tendency to wait-and-see before repositioning our portfolios can be a difficult, but worthy, goal for investors to pursue. Advisors can help investors surmount this and other behavioral hurdles by adopting a systematic rebalancing approach that effectively institutionalizes contrarian investment behavior.

This is the eighth and last article in a series that focuses on the investment role of financial advisors. Previously, we have discussed the major contributors to successfully meeting the long-term financial goals of investors: starting yield, risk, diversification, manager selection, portfolio construction, performance measurement, and taxes.

According to a recent Wells Fargo/Gallup Survey,¹ 31% of investors would opt to spend an hour stuck in traffic rather than spend that time rebalancing their portfolios. Why would we subject ourselves to gridlock instead of performing a simple task such as rebalancing a portfolio? With our office near Los Angeles, the most congested city in the world,² we are certainly no strangers to traffic, so we will venture a guess.

It may well be that for many investors, rebalancing feels worse than rush hour. When we’re stuck in traffic, at the very least we’re in the comfort of our cars and can find other productive ways to pass the time, such as listening to the radio, podcasts, or audiobooks. In contrast, rebalancing forces us to endure the discomfort of buying assets that have just inflicted pain from underperformance and of selling recent winning assets.³ Even worse, rebalancing our portfolios may induce additional pain if momentum carries prices further from fair value. On the highway, our GPS provides helpful estimates of our arrival time, but no GPS is available to pinpoint when market cycles will end: fair value may take months, years, and sometimes even decades to assert itself.

But if we broaden our perspective beyond the salience of the here-and-now to focus on what will ensure our long-term physical and financial well-being, the picture flips. Over time, traffic congestion inadvertently leads to damaging effects on our wallets, health, and environment.⁴  In contrast, a disciplined rebalancing approach continually positions our portfolios to reduce risk, raising the likelihood of our being able to improve risk-adjusted returns over those of an asset mix whose weights drift with price movements. In short, consistent rebalancing is a reliable, and often underappreciated, source of higher risk-adjusted performance for the patient investor.

Rewards Of Disciplined Rebalancing
Because rebalancing our portfolios may induce pain, and even punish us with short-term losses, it becomes even more crucial to keep the end destination—to increase the likelihood of our achieving better investment outcomes over time—forefront in our minds.

Rebalancing allows an investor to maintain the desired risk exposure of a portfolio over its life. The expected volatility of a portfolio with an initial 60/40 allocation to stocks and bonds will change if a bull market in equities has pushed its asset mix to 80/20. According to the Research Affiliates Asset Allocation Interactive (AAI) tool on our website, as of June 30, 2018, a 60/40 portfolio has an expected volatility of 8.6% compared to 11.4% for an 80/20 portfolio—a 30% increase in volatility! By regularly rebalancing portfolios, investors can maintain an exposure to risk that matches their tolerance.

Along with reliably reducing risk, rebalancing also has the potential to increase return. Over the long run, a rebalanced mix delivers better risk-adjusted returns compared to an asset allocation that merely drifts with price movements. As we will discuss later in the article, the benefits of rebalancing arise from opportunistically capitalizing on human behavioral tendencies and from long-horizon mean reversion in asset class prices.⁵

A quick study of two investor portfolios illustrates how a simple rebalancing practice can improve a portfolio’s risk-adjusted performance over time. For simplicity we assume each portfolio begins with the classic 60/40 mix of core stocks and bonds, although we acknowledge the benefit from rebalancing may rise as market breadth increases (Aked et al., 2017) or when rebalancing is applied within an asset class. We show the results across four major developed countries for time spans through June 30, 2018: United States, Germany, Japan, and United Kingdom.⁶

The disciplined investor who systematically rebalances on an annual basis⁷ is Methodical Mary. Without fail, Mary brings her asset mix back to the initial 60/40 allocation at the end of each year. At the other end of the spectrum is Drifter Drew, who also begins with a 60/40 stock/bond allocation, but who lets his portfolio price drift⁸ without ever rebalancing.

We observe a benefit from systematic rebalancing in each of the four geographies over the respective time spans we analyzed. Methodical Mary’s adherence to her predetermined plan beats Drifter Drew’s hands-off approach in each case.