Portfolio Rebalancing. It Is Not For Everyone, It Is Not For Everything.
Imagine a portfolio composed of ten different assets, each of them representing ten percent of the portfolio’s total capital. Over time, each of those assets will perform differently making the distribution of the portfolio's capital less organized, with some assets representing more and others less than the original ten percent.
The idea behind portfolio rebalancing consists in reorganize the portfolio giving back to each of the assets the original share (ten percent in the case illustrated above). It means that one needs to sell part of the best-performing assets and buy more of the least-performing assets.
When this procedure is done on a regular basis, the portfolio is kept with the desired diversification, which helps to keep the portfolio volatility under control.
The Theoretical Additional Return
Assuming that, over time, the prices of investment assets move in cycles out of phase with each other, it is easy to see that the rebalancing process helps to systematically buy the cheap assets at the beginning of their cycles and sell the expensive ones at the end of their cycles.
That characteristic attracts many investors seeking better portfolio performance, after all, the system makes sense.
Unfortunately, this is not the foolproof strategy you might be looking for. I would say it’s quite the opposite.
The problem here is that this additional return is purely theoretical and based on the assumption of beautiful and well-behaved assets cycles. But the reality can be quite different and it might surprise you.
Small Cycles And Big Trends
In the financial market, many assets can make very strong and directional movements on price. These strong moves make the cycle behavior almost insignificant for a particular asset.
In that case, play the cycles in an attempt to buy cheap and sell expensive is useless for the investor.
Imagine, for instance, you have two stocks in your portfolio, let's say “MOON” and “HELL”, and you are rebalancing this portfolio in order to keep a share of 50% for each stock.
Both stocks have a very directional move on price, which makes the cycling behavior insignificant. After few years “MOON” was valued more than a hundred times while “HELL” went bankrupt.
Well, in that case, thanks to the rebalancing process, what you have now is something close to zero dollars, since all gains from “MOON” were little by little allocated in “HELL”.
The scariest thing is that it only takes one “HELL” to drain the portfolio value, it doesn’t matter how many “MOONs” you have.
The Underperformance In Practice
The lifetime return of stocks is very polarized. Many stocks have exceptional returns and many other terrible results.
The chart below shows the lifetime returns for individual US stocks that traded on the NYSE, AMEX, and NASDAQ since 1983.
From the chart above, it’s clear the presence of fat tail on the returns distribution. The lifetime return for the entire portfolio is positive, since winning stocks easily compensate for the losses from losing stocks.
The situation becomes very different if analyzed from a different perspective. For example, if instead of accounting for the total lifetime return, the total annual return is counted. In that case, the mean compounded annual return is negative, as shown in the next chart.
A negative mean compounded annual return means that if the original portfolio was rebalanced every year, the final result would be a loss. This occurs due to the transfer of capital from the consistent winning stocks to the consistent losing ones.
From Balanced To Over Concentrated
As seen above, the rebalancing procedure can make huge damage to the portfolio's return. Even though, many investors feel tempted to rebalance their portfolios after realize that their initial diversified portfolio is becoming too much concentrated over time.
The portfolio concentration happens over time due to the fact of some stocks having exceptional returns while the majority shows low or negative return. In reality, as it shows in the next chart, only 25% of stocks account for all gains in the market.
An alternative to rebalancing in order to avoid over-concentration of a portfolio is just over-diversify since the beginning. For example, if you are comfortable with a portfolio with 10 assets, it’s better to allocate 50 assets then. That way, the 50 assets portfolio that looks too diversified is going to get more and more concentrated over time, naturally increasing the share of the winning assets.
A Strategy For Few
It’s common to hear analysts defending the practice of portfolio rebalancing, but although this practice works incredibly well in very specific cases, it is not a general rule, since it can lead some investment portfolios through a path of very poor performance.
An investor must understand very well the dynamics and risks of specific assets in a portfolio before considering rebalancing it. But, probably, for most cases of long-term investment portfolios, the best one can do is be totally passive, buy and never sell, and accept the fact that investments will become less diversified over time.
