Why bother rebalancing your investment portfolio and what is the best method for doing so.
Topics covered include:
- How a target asset allocation can get out of line if a portfolio is not rebalanced
- What is positive skewness and why it matters to portfolio investing
- What is volatility drag and how it can lead to lower end of period wealth
- What are the costs of rebalancing
- Which rebalancing method if any has been the most effective
Welcome to Money For the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I’m your host, David Stein. Today is Episode 356. It’s titled How, When, and Why Should you Rebalance your Investment Portfolio.
Approaches to Rebalancing
When I was an institutional investment advisor, I would meet quarterly with many of our clients; we would go over performance, potential portfolio changes, asset allocation, but invariably, we would also look at rebalancing their portfolio. It wasn’t always easy to do because some of the assets were illiquid, such as venture capital or private real estate. Rebalancing involves selling assets that are overweight their strategic target and allocating the proceeds to assets that are underweight the target. Because many of the assets were illiquid, oftentimes, rebalancing would focus on the public, more marketable investments.
Now there are a number of ways to approach rebalancing. It can be done on a calendar basis, it could be monthly, quarterly, annually or it could be a threshold approach, a tolerance band. We rebalance when an asset is over or underweight its target by three percentage points or five percentage points.
In this episode, we’re going to take a closer look at rebalancing. I pulled all the relevant research I could find over the past decade with regard to what is the best approach to rebalancing, and why would we even need or want to rebalance?
Let’s address that first question. Why rebalance? A pure buy-and-hold portfolio has a major drawback, in that because stocks tend to outperform bonds, if an investor has both, over time, the higher-performing asset class, in this case, stocks will become a larger and larger percentage of the portfolio.
I saw one academic study that gave an illustration that a US stock and bond portfolio that was 60% allocated to stocks in 1927, if the portfolio hadn’t been rebalanced by 1929, stocks would comprise 76% of that portfolio. But in 1932, because of the 1929 crash, if that portfolio hadn’t been rebalanced, stocks would comprise 32% of their portfolio. Then over time, stocks would have reached 100% of the portfolio.
So there’s a logical aspect to rebalancing that if there is a target, a portfolio could deviate dramatically from that target if it’s never rebalanced.
Portfolios that have more stocks are more volatile. The higher the volatility, the ups and downs of a portfolio, the more positively skewed it is. Skewness is a statistical term. It means that the median or middle return will be less than the expected return because more of the observations are less than the expected return. Which means if you have a portfolio that’s positively skewed, there’s a greater likelihood that the portfolio will fall below expectations; it will not meet its expected target, although there will actually be a few periods where it significantly outperforms and does better than the expectation.
So if we’re just looking at a distribution of the outcome, it’s something that’s positively skewed, it’s not normally distributed with the expected outcome or expected return being in the middle and an even distribution on each side. A positively skewed distribution has more of the outcome to the left of the expected outcome, but there’s a fatter tail to the right of the expected outcome, with fewer observations, but observations that can do significantly better than expected.
Interestingly, academics have shown that individual investors like investments that are positively skewed. Think of all the hype that some of these meme stocks have gotten, where the expectation is for huge outperformance. Investors can be attracted to that. Even though investors might have loss aversion, losses viscerally feel worse than gains. Investors also do what’s known as narrow framing. They just look at an investment outside of the context of the rest of the portfolio, their employment, they just look at that and they see the potential opportunity, and because it’s positively skewed and there can be a huge win, that can be attractive. We don’t want to fall into that trap when considering our overall portfolio.
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