If you have an asset allocation set up, maintaining that asset allocation forces you to buy low and sell high on a constant basis. This is because the individual asset classes have different return patterns. If you were to start with 60% in equities and 40% in fixed income, then invariably this split will drift from 60/40 over time. You might find equities outperforming bonds, in which case your allocation might drift to 70/30. Or, vice versa stocks might drop if the markets have a correction and your mix might drift to 50/50.
Rebalancing Goes Against Emotions
If stocks dropped, human nature might make us avoid wanting to rebalance since that would mean shifting money from well performing assets to buy ones that have been lousy as of late. But, keep in mind you would be buying low and selling high. You would be buying stocks at a potential low, and selling your bonds at a potential high. Let’s take a simple example to see how this might help a portfolio.
Thanks again to DFA’s very powerful Returns 2.0 software, I have pulled up the actual performance of the TSX Composite Index and the DEX Universe Bond Index from January 1st, 1980 to August 31st, 2008 – almost a full 29 years. I compared a simple 60% Equity / 40% Fixed Income portfolio that never rebalances to a similar portfolio that rebalances only once per year.
The annually rebalanced portfolio earned an annualized 10.51% return (assumes no transaction costs or other fees), whereas the portfolio that never rebalanced earned 10.25%. For a $10,000 initial investment, this translates into a $11,500 difference at the end of these 29 years. Here is the performance graph from the software:
(Click to enlarge)
Keep in mind this is a simple analysis. There’s more to discuss when it comes to rebalancing. For example – the annually rebalanced portfolio was actually slightly more volatile than the non-rebalanced portfolio (10.64% SD versus 10.25% SD respectively). There are probably better ways to pick a rebalancing schedule – i.e. based on a set deviation from your target allocation as opposed to based strictly on time periods, etc…
Can anyone else get a copy of that nifty Returns 2.0 software, or is it only available to DFA investors or maybe only certified advisors?
Is the software able to provide a graph based on dollar value averaging instead of fixed rebalacing? After reading Four Pillars by William Bernstein I believe it is an effective systematic strategy to buy more shares when they are low and even sell when they are high. Emotionally it would be even hardly to pull off, but I’d like to see if DFA’s stats backup the claim since it supposedly could boost returns by a percent or two.
Thanks, Jordan
@Jordan – software is restricted. Dollar value averaging analysis would have to be done the hard way – I’ve never seen a software package that can perform DVA with actual historic market data – would be pretty cool though!
Preet, if the difference between a portfolio that is rebalanced and one that isn’t is so minimal after 29 years, isn’t that suggesting that rebalancing does NOT make a difference?!……. Debra
@ Deb – excellent question. Keep in mind that the early 80’s had bond returns over 20% in four of the first 5 years – this skews the data quite a bit. Since 1992 or 1993 the government has introduced a policy to target the inflation rate between 1 and 3% so that periods of such high inflation as in the early 80’s doesn’t occur again.
If we just look at the past 10 years, with a 50%/50% mix then annual rebalancing versus no rebalancing will give you 9% more money in your pocket, with less standard deviation. 9% is pretty significant.
Due to the tremendous nominal returns for bonds in the 80’s, the DEX universe bond index has a 25 year annualized return of 9.69% to the end of August 2008.
So this is just rebalancing between equities and fixed income, not within classes of equities? Were any transaction costs put in with the rebalancing?
@Potato – I indicated in the post that no transaction costs were assumed. The rebalancing was to the original target weights within the equity allocation classes, i.e. not just equity to fixed income.
Over the last few years rebalancing has paid handsomely! Invest wisely.
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