Buy low, sell high…maybe the most obvious axiom in investing. It seems so obvious, yet in practice, most investors have difficulty buying the worst-performing assets or selling the best-performing assets. “Wait…you want to sell this thing that’s been going straight up so we can buy this other thing that’s been terrible?” Yet buy low, sell high or, in the more technical parlance of the profession, rebalancing, is a key aspect of the discipline required to be a successful investor.
Three important reasons to rebalance:
- Maintains a consistent exposure to the target asset allocation
- Systematically allocates capital toward asset classes with increased expected returns
- Overcomes behavioral biases that lead to poor investment decision-making
To understand how rebalancing impacts portfolio performance over time, we can create a simple 60% equity/40% fixed income portfolio. The equity component is represented by the MSCI All Country World Index and the fixed income allocation is represented by the Bloomberg Barclays US Aggregate Bond Index. Two versions of the portfolio were compared over the period beginning at the peak of the S&P 500 prior to the 2008 financial crisis, on October 9, 2007, and ending on August 14, 2018. One version is a buy-and-hold strategy and the other is a rebalanced strategy. The rebalanced portfolio makes buy-and-sell trades whenever either asset class drifts 10% away from its target (i.e. the equity allocation will rebalance at 6% above or below its target of 60%).
Consistent Exposure to Target Allocation
We can see the impact of systematic rebalancing on the portfolio allocations through time by examining the buy-and-hold and rebalanced portfolios versus their targets.
The charts compare portfolio weights over time with the equity allocation shown in blue. The chart on top shows the buy-and-hold portfolio with the rebalanced portfolio on the bottom. The critical issue here is that at the depth of the financial crisis, the equity allocation of the buy-and-hold portfolio had shrunk to roughly 40% from the initial 60% target. Thus, it experienced a 33% reduction of equity –– down 20 percentage points from 60% –– at exactly the wrong time. Alternatively, the disciplined rebalanced portfolio maintained 100% of the target allocation to equities throughout the crisis. This consistent exposure to equities improved portfolio performance when markets ultimately rebounded.
Systematically allocates capital toward asset classes with increased expected returns
By systematically buying the underperforming asset classes, the rebalanced portfolio will always have adequate exposure to the asset class that has increased expected returns. The chart below shows the results of $1 million invested in each of the two portfolios. The vertical lines on the chart denote when rebalancing trades would have been made. By the end of the period, the rebalanced portfolio gained almost $100,000 more than the buy-and-hold version with just slightly more volatility.
Source: Kwanti, October 9, 2007 – august 14, 2018
Overcomes behavioral biases that lead to poor investment decision-making
Warren Buffet is quoted as saying, “Investing is simple, but not easy.” He was likely referring to investing in general, but that saying is particularly relevant in regard to rebalancing. Pick a target allocation –– say 60% stocks, 40% bonds –– and based on some rule (either tolerance bands or timing), as markets fluctuate over time, trim the asset that becomes overweight and, with that money, buy the one that is underweight to return to the original target.
Simple enough, but easy? No, not for most people. Why? Because both outside influences and internal wiring make the consistent execution of rebalancing very difficult. Outside influences include media, friends, acquaintances, and (maybe most of all) family, who are likely caught up for varying reasons on the most exciting investment topics of the day. By internal wiring, I’m referring to known behavioral biases such as herd mentality (the tendency for investors to move more money into stocks after markets have risen sharply) and regret aversion (the tendency for investors to sell investments that have gone down to attempt to correct a perceived mistake) that cause investors to make systematic mistakes.
Buy low, sell high is smart advice. Done systematically, we call it rebalancing. Rebalancing keeps investment portfolios in line with targeted risk levels, maintains exposure to equities during down markets, and helps offset human tendencies to make poor investment decisions. Rebalancing is a crucial component of the discipline required for successful investing.