Is Portfolio Rebalancing Necessary?

Portfolio rebalancing is taken as an article of faith by many investors and financial advisors, believing that it helps to control the risk in an investment portfolio at a level appropriate to the investor’s risk appetite, even at the cost of giving up some investment returns. But this is not what some well known investors like Benjamin Graham, or Warren Buffett subscribe too, believing more in their investment thesis and not giving up future gains.

We find that there is no conclusive evidence that portfolio rebalancing is the best approach for every situation and investing environment – in some cases, not rebalancing actually helped to reduce overall risk! So is portfolio rebalancing necessary? Not always, even for passive investors who do not have a view on the direction of the assets they are holding.

Is rebalancing your investment portfolio necessary? Portfolio rebalancing is usually defined as the process of realigning the weightings of a portfolio of assets. For instance, rebalancing involves periodically buying or selling assets in a portfolio to maintain an original or desired level of asset allocation or risk. While this seems like a commonsensical thing to do, here’s what the Dean of Wall Street had to say about this:

It is for these reasons of human nature, even more than by calculation of financial gain or loss, that we favor some kind of mechanical method for varying the proportion of bonds to stocks in the investor’s portfolio. The chief advantage, perhaps is that such a formula will give him something to do. As the market advances he will from time to time make sales out of his stockholdings, putting the proceeds into bonds; as it declines he will reverse the procedure. These activities will provide some outlet for his otherwise too-pent-up energies.
Benjamin Graham, The Intelligent Investor

It is not surprising that portfolio rebalancing does not figure highly in the practices of Benjamin Graham, or other notable investors like Philip Fisher, or Warren Buffet. After all, they invest on the basis of their convction that a particular stock is mispriced, and until such time when it is fully priced by the market, or where the investment thesis has changed, there is no reason to buy or sell simply to rebalance the portfolio.

In more recent years, there is no shortage of views either for or against portfolio rebalancing (see links in References below), which shows that this is a question where there is no clearcut answer to. Sometimes it works to produce better returns, but sometimes it does not. But most of the time, it is believed to contain the risk in the portfolio to a specific level.

This is perhaps the reason why portfolio rebalancing still remains a common practice. With the growth in investors entrusting the investment decisions to fiduciaries such as financial advisors and investment committees and managers, these fiduciaries are often in the position where they cannot guarantee the returns on the portfolio (nobody can!), but they can, at the very least, commit to constrain the risk of the portfolio within the bounds of the principal’s risk appetite. If you are managing the portfolio for yourself, and are only answerable to yourself, then you would be in a better position to decide whether you would want to live with the higher risks of not rebalancing when the opportunity arises.

Was portfolio rebalancing useful in the past 15 years?

So let’s take a break from the theory and look at whether portfolio rebalancing was useful in for both SGD and USD investors over the past 15 years. Let’s also look at whether semiannual or annual rebalancing works better. Obviously, this is just one run of history in fairly unique circumstances, and so it is not meant to settle the argument one way or the other. As a further quirk, we shall also look at whether it makes any difference when the investor is accumulating (during working years) or decumulating (during retirement years).

We start off by setting up two portfolios which are roughly 60%-66% in equities and 33%-40% in bonds. The ETFs used to set up these portfolios are:

STI ETF – ES3
S&P 500 ETF – SPY
ABF SG Bond ETF – A35
MSCI EAFE ETF – EFA
US 20 Year Treasury Bond ETF – TLT
US 10 Year Treasury Bond ETF – IEF

Initial asset allocation for the SGD portfolio

Initial asset allocation for the USD portfolio

The period we will look at is from 2006/2007 to the start of 2020. Why this period? This is chosen so that the USD portfolio starts and ends at the peak in the stock market, rather than getting a misleading outcome by starting at the bottom of the market (2002, when the TLT and IEF ETFs were listed) and ending at the peak.

For the rebalanced portfolios, we look at rebalancing every 6 months, and every year, with the dividends collected between the rebalancings accumulated as part of the total value of the portfolio. In the no rebalancing case, we shall only allocate the dividends collected to new investments based on the original asset allocation.

How did the SGD investor fare?

Let’s start by considering a SGD investor who splits his portfolio between domestic shares, domestic bonds, and foreign shares. The chart below shows the progress for an investor who is focused on accumulating only:

Rebalancing versus no rebalancing for an accumulating SGD investor

SGD Portfolio rebalancing - Accumulative

And here are the outcomes for the retired SGD investor, who needs to draw 4% (adjusted for inflation) from the portfolio every year. This chart has a much lower return than the previous one, which is logical given the need to withdraw from the portfolio every year.

Rebalancing versus no rebalancing for a decumulating SGD investor

SGD Portfolio rebalancing - decumulative

How do the results shown graphically above look, in numbers?

	Total Gain (%)	Average Yearly Gain (%)	Annualized Volatility (%)
No rebalancing (Accumulating)	113%	6.0%	10.6%
Annual (Accumulating)	124%	6.7%	10.9%
Semiannual (Accumulating)	119%	6.5%	11.1%

No rebalancing (Decumulating)	12%	1.3%	10.5%
Annual (Decumulating)	24%	2.4%	12.0%
Semiannual (Decumulating)	21%	2.2%	10.9%

From the numbers above, there is no clear trend one way or the other. While the no rebalancing case always ends up with the lowest return, it also has the lowest volatility. In any case, the differences in return are not statistically significant. In fact, the differences in returns seem to have been mainly driven by the rebalancing back into the S&P 500 in Jan 2009, which is roughly when the bottom of the 2008 Global Financial Crisis was. On the other hand, the lower volatility in the no rebalancing case is surprising, given that the weights between the different ETFs move by quite a bit over time.

Weights of the components of the SGD portfolio with no rebalancing

What about the USD investor?

The outcomes for the USD investor who splits the portfolio 60:40 between stocks and bonds tell pretty much the same story as before. In the no rebalancing case, the investor ends up with a lower return over the past 15 years, as compared to the rebalancing case. However, as before, these results are not statistically significant.

Rebalancing versus no rebalancing for an accumulating USD investor

Here are the outcomes for the retiree USD investor, who draws 4% (adjusted for inflation) of the initial portfolio value from the portfolio every year. Just as before, this chart has a lower return to the portfolio than the accumulating case, given the need to withdraw constantly from the portfolio.

Rebalancing versus no rebalancing for an decumulating USD investor

And the numbers also tell us the same story, that the rebalancing case actually had a lower volatility than the rebalancing cases:

	Total Gain (%)	Average Yearly Gain (%)	Annualized Volatility (%)
No rebalancing (Accumulating)	121%	6.5%	7.8%
Annual (Accumulating)	120%	6.6%	8.4%
Semiannual (Accumulating)	130%	7.0%	8.7%

No rebalancing (Decumulating)	18%	1.5%	7.5%
Annual (Decumulating)	24%	1.9%	8.3%
Semiannual (Decumulating)	26%	2.3%	8.5%

Again, the USD investors who did not rebalance had quite a wild ride in terms of the swings in the asset weights. For example, the weight in the S&P500 ETF started off at 40%, then dropped to 30% during the 2008 crisis, and then surged past 50% over the past decade on the back of large gains. However, as the weight on the other equity ETF dropped from 20% to 10% over the same period, the overall allocation to equity, of 60% was quickly restored after 2009. Hence, these investors came out of the past decade with lower volatility over the entire period.

Weights of the components of the USD portfolio with no rebalancing

Weights of the components of the SGD portfolio with no rebalancing

Conclusions

It is not often that we end a post on an inconclusive note, but there is first time for everything! In fact, that has been exactly what we have uncovered here. Investors and advisors have taken it almost as an article of faith that portfolio rebalancing is absolutely necessary, even at the cost of giving up some returns. However, this conclusion depends on the period in question, and as we show here, there can be instances where portfolio rebalancing actually helps to increase returns and reduce overall risk!

This is in line with the observation that investing is as much an art as it is a science. It also reinforces the view that it is the investment thesis behind the asset allocation and stock selection that sometimes plays a more important role in investing, than the asset allocation itself.