Rebalancing (Part 2)

The second chart above summarizes the results of the rebalancing test conducted last week (the first chart conveys the Alpha and Sharpe Ratio, which although interesting to me and potentially others, are not really salient to this post). Essentially, the take-away is: "When there's no trend, rebalancing is your friend" (I'm a poet and didn't know it). In other words, when the stock market is range-bound (i.e. oscillating back and forth with no consistent direction) as illustrated in 'Phase I' of the chart, then the practice of selling your winners and buying your losers will outperform a buy&hold strategy. The reason is because 9 times out of 10, the stocks that perform the best when the market rises will perform the worst when the market falls. In fact, it's this tendency that is captured by the statistical metric, Beta.

However, when there is a strong trend as illustrated in 'Phase II' of the chart, then rebalancing will underperform the buy&hold strategy. That's because as the overall market continues to rise, the same stocks with higher betas continue to outperform. If you're consistently selling these stocks and reinvesting in the underperformers... you get the picture.

In 'Phase III' of the chart, you can see the sharp reversal in the overall market. Since the rebalanced portfolio contains less of the high beta stocks when this reversal occurs, its total value declines less than the buy&hold portfolio. So in the end, rebalancing ended up roughly equal to the buy&hold strategy with less volatility along the way. However, at the peak of the market, the rebalanced portfolio was approximately 15% lower than the buy&hold portfolio. You would have needed the emotional fortitude and conviction to stick with your rebalancing strategy for roughly 5 years while it underperformed the overall market from 2004 through 2009. Otherwise if at some point you abandoned the rebalancing strategy and let your high beta stocks become a larger component of your portfolio, then you would have experienced more of the subsequent market downturn and your portfolio would not have caught up to the buy&hold portfolio.

This all highlights one of the central tenants of investing: strategy matters, but unless you can accurately time the market, consistency matters more. So what's the conclusion? For me, I don't think it's worth rebalancing in my regular brokerage account that is subject to taxes on the gains because the tax costs would overwhelm the small benefit of rebalancing. However, for my IRA accounts that are not subject to taxes, when I'm eventually able to move them over to Folio Investing (zero trading commissions except for an annual fee of $290), I will rebalance on occasion in order to mitigate the portfolio volatility and perhaps eke out an incremental return advantage in the really long-run. But rather than rebalancing every week, I may choose to rebalance only when I expect the market to experience a reversal (thoughts on market-timing strategy to come in later posts).

Footnote 1: this insight as it relates to rebalancing being akin to market-timing isn't often mentioned in the typical investing books you might find at your local Barnes & Noble. It is however expounded upon in an excellent book called "The Intelligent Portfolio", which is based on insights from Bill Sharpe, who won a Nobel prize for his work on option pricing theory. If nothing else, you should spend the $20 on the book just for the included free 1-year subscription to Financial Engines, which is an excellent tool that conveys your probability of achieving an adequate retirement nest egg based on your financial plan, with the analysis based on Monte Carlo simulation (state of the art for financial planning).

Footnote 2: You may have noticed this portfolio of 10 stocks pretty much doubled in value over a time period when the overall market essentially went nowhere. That is primarily a quirk of choosing the 10 stocks now, rather than back in 2000, which reflects Survivorship Bias. For instance, if I were choosing 10 stocks back in 2000, I may have selected Lehman Bros. (which went bankrupt) rather than JP Morgan.