Why Rebalancing Could Be a Huge Mistake
Reprinted courtesy of MarketWatch.com.
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Conventional wisdom holds that regular rebalancing is a sound practice to control investing risk. But I’ve concluded that some of that conventional wisdom is wrong.
After preaching the gospel of rebalancing for decades, I’ve come to a startling conclusion: Rebalancing among equity asset classes is unnecessary and may even be counterproductive.
Before you conclude that I have totally lost my mind, let me emphasize the part of the “rebalancing gospel” that’s still intact. It still makes very good sense to rebalance regularly, perhaps once a year, between stocks and bonds.
This lets you set an overall risk profile for your portfolio—for example 60% equities and 40% bonds—and maintain that profile through the ups and downs of the stock market. You know the drill: After a big decline in stocks, buy more (by selling bonds) at low prices; after a big run-up in prices, sell some stocks (when prices are high) and buy bonds.
This is a good strategy. If you didn’t do this, over time you would most likely wind up with a portfolio that’s increasingly heavy on stocks—perhaps 70% when you wanted 60%. That would leave you with a higher risk profile.
For many years I’ve said the same thing about various equity asset classes. To use a simple example, if you start with equal percentages of large-cap stocks and small-cap stocks, that balance will tend to get out of whack at some point. That means it’s time to rebalance, right?
As it turns out, maybe not.
For some time I have harbored suspicions about this point of faith. So recently I decided to test it with a little research. I focused on four U.S. equity asset classes: large-cap stocks, small-cap stocks, large-cap value stocks and small-cap value stocks.
These four asset classes have very different long-term returns, and I believed it was prudent to rebalance them annually. Just about every other professional adviser believes that.
Using 50 years of data from Dimensional Fund Advisors (1963 through 2012), I found that the S&P 500 index (representing large-cap stocks) compounded at 9.4%, large-cap value stocks compounded at 12.4%, small-cap stocks compounded at 11.8%, and small-cap value stocks compounded at 16.7%.
What return would have been produced, I asked my computer, from a portfolio that started in 1963 with equal amounts of those four asset classes, with annual rebalancing? The answer was encouraging: 12.8%. That’s higher than three of the individual asset classes.
That is a testimonial to the merits of diversification.
But annual rebalancing would have usually (although not always) dumped more money into large-cap stocks, the least productive of these four. If the portfolio were never rebalanced, it would have compounded at 13.9%.
Over half a century, that extra 1.1% made a huge difference. Assuming each asset class started with $10,000, the portfolio would have grown to $6.6 million without rebalancing, versus only $4.2 million with rebalancing.
Rebalancing, in other words, cost the portfolio $2.4 million, taking away 36% of its gains. That’s a very steep price to pay. What benefit did the portfolio receive in return?
Rebalancing is supposed to reduce risk. Over this 50-year time span, did that happen? I could not find any compelling evidence that it did.
One obvious risk is having most of your money in one asset class—in this 50-year period it was small-cap value. In a time of market catastrophe, that leaves you very exposed.
The closest thing in recent memory to a market meltdown was 2008. Not surprisingly, that was the year that each of these asset classes had their biggest losses (at least in the past 50 years). In that awful year, the S&P lost 37%, large-cap value lost 39.1%, small-cap lost 38.6%, and small-cap value lost “only” 32%.
If you had never rebalanced, you would have started that year with the majority of your money in small-cap value. And although nobody could have predicted it, that asset class lost less money that year than the others. Though losing money is never nice, this would have at least helped you preserve some of your assets.
To test my theory further, I looked at what happened to these four asset classes in the four years 1929 through 1933. That should be a severe test. I was a bit surprised to find that the compound return (actually compound loss) was almost identical whether or not the asset classes were rebalanced. Rebalanced each year, the portfolio lost 76.9%; without rebalancing it lost 76.6%.
So what is an investor to make of all this? For starters, everything about the future is unknown—which is true of all aspects of investing. The patterns of the past 50 years might or might not continue. My data includes only four U.S. equity asset classes, without any international representation.
However, I have no reason to believe the dynamics of rebalancing will change fundamentally in the future, and I see no reason to believe the same pattern won’t apply to international stock investing.
So here’s my advice, in three parts.
First, all investors should continue to rebalance between stocks and bonds. This is a legitimate tactic for controlling risk.
Second, young investors probably will do better over the long haul if they don’t rebalance among equity asset classes. Remember the $6.6 million (no rebalancing) versus $4.2 million (annual rebalancing) over the past 50 calendar years.
Third, older investors, certainly including retirees, should be more conservative and not let any single asset class get too far away from its target percentage. For these investors, rebalancing is probably a good idea. It doesn’t have to happen every year, but it should happen at least every four or five years.
This analysis takes a big chunk out of the conventional wisdom, without overthrowing it altogether. If you would like to know more, I have recorded a podcast just for you.
Richard Buck contributed to this article.