The Discipline of Rebalancing

A working paper published by the National Bureau of Economic Research (NBER) tackled the subject of “optimal inattention to the stock market.” It’s an interesting concept that at first seems backwards: gauging the extent to which we should not pay attention to our investments.  Normally an investor thinks in terms of how often to monitor, analyze, fret over, dabble with, and adjust his or her portfolio in hopes of avoiding some trouble brewing in markets or taking advantage of a temporary market dislocation. But the researchers assume a continuum between never making portfolio adjustments and constant, even daily adjustments to find the “sweet spot” for rebalancing which brings together the need to stay on track and the need to keep costs in check. As it turns out, leaving the portfolio alone and simply rebalancing on a very occasional schedule may often represent the best investment decision.

Rebalancing becomes relevant after you have chosen a mix of stocks, bonds, and other assets that represents an appropriate long-term “strategic” pathway to returns. As the various investment markets move differently over time, some investments must be sold and others purchased to keep a portfolio blend in line. After all, the proportion of risky “growth” assets in a portfolio tends to be the largest determinant of how the overall portfolio performs over time. Drifting too far away from the target means the risk profile has changed, and along with it the potential returns.

Rebalancing provides two main benefits to the investor. As mentioned, it keeps a portfolio on track with the long-term strategy and helps keep risk closer to long-term expectations. But it also potentially adds to returns because rebalancing regularly introduces a natural bias toward purchasing assets which have decreased in value and selling assets which have increased in value. In a market which oscillates, this can provide a “rebalancing return” when prices snap back in the other direction. In addition, over the long run rebalancing introduces a “value bias” to returns, which correlates with higher long-term returns in much academic literature.

But the questions about method and frequency remain open. The NBER researchers believe optimal inattention leads to rebalancing only once every couple of months or longer. This finding also implies that investors should not expend the time to review the portfolio except according to a schedule that works. At KeatsConnelly, we prefer to rebalance to the target equity-versus-fixed income ratio when prices move beyond our comfort threshold, generally 6%. In most markets, rebalancing does not take place more often than quarterly. Within asset categories, where rebalancing may provide less return or risk reduction, we review portfolios on a scheduled basis throughout the year and make adjustments when the trade size seems large enough to warrant action. Trades usually involve transaction costs and taxes, so a rebalancing discipline needs to consider the cost versus the expected benefit.

While different rebalancing approaches differ in the specific market conditions which allow them to perform best, we will never know in advance the optimal approach. In general, regular rebalancing and a disciplined allocation serve investors well, and we believe this will continue to be the case going forward.

For further reading, please refer to the following links:

http://knowledge.wharton.upenn.edu/article.cfm?articleid=3319 (This article summarizes the original NBER paper.)

http://www.nber.org/papers/w15010 (A 2009 working paper including the research.)

http://www.researchaffiliates.com/Our%20Ideas/Insights/Papers/Documents/AAII%20Journal%20Dec%202012%20-%20Hsu.pdf (Discusses how rebalancing introduces a value bias.)

http://www.cfainstitute.org/learning/products/publications/contributed/Pages/best_practices_for_portfolio_rebalancing.aspx

www.stanford.edu/class/msande348/papers/PeroldSharpe.pdf (Discusses different rebalancing methodologies and the markets in which they do best.)

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