Current Thinking

Portfolio Rebalancing in the Recent Market Environment-Revisited

Record stock market highs have made it tempting for investors to allow their portfolio to “ride” the trend of these returns without adjusting their asset mix. How can investors keep their portfolio allocations from drifting too far from their desired target allocations and potentially increasing their exposure to sudden market downturns-such as in 2008, late 2018 and the first quarter of 2020? A well-known form of adjustment is known as rebalancing. I first posted a blog on this subject in the 2017 Current Thinking.

Rebalancing can be defined as reducing the percentage of the portfolio in the higher performing asset class(-es) and increasing the percentage in the underperforming asset class(-es), in order to maintain one’s desired target asset allocation. Rebalancing can be done either on a calendar basis (monthly, quarterly, and annually) or when a threshold is exceeded (e.g. when stocks appreciate by 10% or more versus bonds over a 4-week period). Given that current equity markets are very richly valued with the added variables of Covid-19, higher interest rates and geopolitical risks, there may be several potential benefits to rebalancing. These include maintaining diversification over the long term; maintaining one’s asset mix within reasonable ranges; and reducing the vulnerability of the portfolio to unexpected market corrections.

While the benefits of rebalancing are always sensitive to the time period involved, it is useful to again illustrate a simple example of a target 60% stock (S&P 500 Index) and 40% bond (Bloomberg Barclays US Aggregate Bond Index) portfolio. The chart below summarizes three rebalancing scenarios:

 

No Rebalancing

 

Monthly Rebalancing

 

Annual Rebalancing

 

Time Period:

Annualized Return

Return /Risk

Annualized Return

Return /Risk

Annualized Return

Return /Risk

1/2008-5/2021

8.40%

     0.87

8.16%

     0.85

8.24%

     0.87

6/2016-5/2021 (5 years)

12.93%

     1.22

11.72%

     1.29

11.60%

     1.29

6/2011-5/2021 (10 years)

10.55%

     1.18

10.08%

     1.23

10.03%

     1.23

Target Stock/Bond Mix

60%/40%

 

60%/40%

 

60%/40%

 

Ending Stock/Bond Mix

77.1%/22.9%

 

59.9%/40.1%

 

64.2%/45.8%

 

Risk is defined as the annualized standard deviation of returns.

Looking at the above table, the greatest benefits from rebalancing were (a) preventing excessive deviation from one’s target allocation and (b) a higher return per unit of risk. With no rebalancing over the 2008-2021 period, the portfolio drifted from its initial 60%/40% target stock/bond mix to 77% stocks and 23% bonds, a far more aggressive allocation. Even just annual rebalancing moved the mix much closer to the 60%/40% target. While monthly rebalancing resulted in the least amount of asset mix drift (actual versus target allocation); an additional consideration with monthly rebalancing is that it may result in significant turnover, trading costs and tax implications. In terms of return per unit of risk (risk-adjusted return), both monthly and annual rebalancing generally generated higher risk-adjusted returns. Additionally, over the 5 and 10 year periods, the worst monthly return was -7.7% with rebalancing and -8.8% with no rebalancing.

In summary, this update confirms my earlier conclusion that it makes sense to look at one’s portfolio allocation versus one’s target allocation on a periodic basis. In the above illustration, a once per calendar year rebalancing had the potential to add value on a risk-adjusted basis, and importantly, to guard against drift in the portfolio’s asset mix due to gains which may suddenly reverse in the future.

NOTE: Information presented herein is for discussion and illustrative purposes only and is not a recommendation or an offer or solicitation to buy or sell any securities. Past performance is not a guarantee of future investment results. Diversification does not guarantee a profit or protect against loss.

About the Author

Frederic Slade

Frederic Slade is Assistant Vice President and Senior Director, Investments at Pentegra Retirement Services. He joined Pentegra in May 2007 as a Senior Analyst in the Investment Department and became Director-Investments in January 2013. He is responsible for managing over $1 billion in internal bond portfolios and providing asset/liability studies, analytics and product strategy for Pentegra’s Defined Benefit and Defined Contribution Plans. Mr. Slade is also a frequent contributor of economic and financial market blogs to Pentegra’s Talk to a Specialist website and the financial media. Prior to joining Pentegra, Mr. Slade was a Senior Quantitative Analyst at Citigroup Asset Management, providing asset allocation and quantitative stock screening for mutual fund products. Prior to Mr. Slade’s tenure at Citigroup, he was an Investment Manager at NYNEX Asset Management (now Verizon). At Verizon, Mr. Slade was responsible for asset allocation and planning for its $15 billion Defined Benefit pension fund. Mr. Slade holds a Ph.D. in Economics from the University of Pennsylvania and a CFA, and is a frequent presenter at industry seminars and conferences.