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Rebalancing Reduces Portfolio Volatility

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Buy low, sell high. It's perhaps the oldest and most familiar of investment axioms. However, investors who neglect to periodically rebalance and let their portfolios run off the leash may not end up living by this mantra.

Identifying one's own risk tolerance, goals, and investment horizon are important tasks when setting up an asset allocation strategy. However, the work doesn't end there. The market is forever changing as certain asset classes fall in and out of favor and allocations within a portfolio get out of whack with their original percentages. Therefore, investors must periodically - perhaps annually - rebalance their portfolios to get back to the initial allocations.

To understand the often-touted benefits of annual rebalancing let's take a look at how two simple portfolios would have held up during the late 1990s - one rebalanced annually and one left on autopilot. Both portfolios start with an equal weighting of assets in large cap stocks (S&P 500 Index), international stocks (MSCI EAFE Index), and Treasury bonds (Lehman Brothers Intermediate Treasury Bond Index).

Let's keep things nice and simple and assume $100 is invested in each of the three asset classes. For annual returns, we'll use index performance from Morningstar. Of course no one gets index returns because all funds have costs, but again this is a theoretical case designed to clearly illustrate the merits of annual rebalancing. This example also assumes no new cash is invested.

Index Name
Standard & Poor's 500
MSCI EAFE
Lehman Brothers Intermediate Treasury Bond Index
1995 return
37.43%
11.63%
14.40%
1996 return
23.07%
6.23%
3.99%
1997 return
33.37%
2.02%
7.69%
1998 return
28.58%
20.25%
8.62%
1999 return
21.03%
27.27%
0.40%
2000 return
-9.10%
-13.95%
10.25%
2001 return
-11.88%
-21.21%
8.16%
Source: Morningstar

Now, let's see what the non-rebalanced portfolio looked like at the end of each year in terms of cash in each asset class.

Non-Rebalanced Portfolio
 
S&P 500 allocation ($)
MSCI EAFE allocation ($)
Treasury Bond allocation ($)
Total
Start
100.00
100.00
100.00
300.00
1995
137.43
111.63
114.40
363.46
1996
169.14
118.58
118.96
406.68
1997
225.58
120.98
128.11
474.67
1998
290.04
145.48
139.16
574.68
1999
351.04
185.15
139.71
675.90
2000
319.10
159.32
154.03
632.45
2001
281.19
125.53
166.60
573.32

Below is the counterpart portfolio that is rebalanced at the start of each year back to the original allocation percentages. Remember, the table below shows what the portfolio looks like at the end of the year before rebalancing.

Rebalanced Portfolio (Annually)
 
S&P 500 allocation ($)
MSCI EAFE allocation ($)
Treasury Bond allocation ($)
Total:
Start
100.00
100.00
100.00
300.00
1995
137.43
111.63
114.40
363.46
1996
149.10
128.70
125.99
403.79
1997
179.51
137.32
144.95
461.78
1998
197.92
185.10
167.19
550.21
1999
221.97
233.42
184.14
639.52
2000
193.78
183.44
235.02
612.24
2001
179.83
160.79
220.73
561.36

The table below shows the annual performance of each portfolio from 1995 to 2001 and the standard deviation of each. Standard deviation is a measure of portfolio volatility.

Year
Non-rebalanced portfolio return
Rebalanced portfolio return
1995
21.15%
21.15%
1996
11.89%
11.10%
1997
16.72%
14.36%
1998
21.07%
19.15%
1999
17.61%
16.23%
2000
-6.43%
-4.27%
2001
-9.35%
-8.31%
1995-2001
9.69%
9.36%
Std Dev. (1995-2001)
12.89%
11.59%

Here's how that looks in a graph.

The most obvious thing going on here is that the rebalanced portfolio didn't rise as high as the autopilot version when the S&P 500 and MSCI EAFE took off. Also, the rebalanced portfolio didn't fall as hard when the bubble burst in late 1999. Although the total returns were slightly lower, the rebalanced portfolio was less volatile, which is a primary goal of annual rebalancing. In other words, the risk-adjusted performance was better in the rebalanced portfolio.

Rebalancing can involve significant transaction costs, so most investors and advisors rebalance portfolios only once a year or when allocation percentages get really out of kilter.

Although the temptation is to let winners run and dump losers, annual rebalancing imposes discipline and ensures that the portfolio will remain diversified in volatile markets. Investors who rebalance admit that they cannot predict which asset classes will outperform or underperform in the future. However, asset classes tend to revert to the mean. Rebalancing reduces the ability to ride asset classes in the market's sweet spot, but it also prevents exposure to market bottoms when asset classes fall out of favor. And that makes for a smoother ride over the long haul.