Morgan Stanley
  • Wealth Management
  • Sep 16, 2015

The Rebalancing Effect

Does rebalancing your portfolio annually create additional return potential and lower volatility versus never rebalancing?

Investing is the ultimate exercise in patience. Historically, major equity and bond markets have delivered positive returns for investors who use a patient, long-term strategy. However, to realize those potential long-term benefits, investors often have to navigate through periods of short-term uncertainties.

An undisciplined approach to trading decisions, particularly during volatile market conditions, can negatively impact performance and make for a difficult investing experience.

However, rebalancing your portfolio annually may create additional return potential and lower volatility versus never rebalancing.

Portfolios Can Change Over Time

For a long-term investor, patience and risk management are key qualities. But patience is different than inattention. Maintaining a mix of investments that deliver returns and manage risk requires timely adjustments, since, over time, there are three common occurrences that can shift a portfolio away from its initial asset allocation.

1. Performance - As assets rise or fall in value, their weights also change based on how they have performed relative to the portfolio. For example, if one asset performs extremely well, while another fares poorly, over time the well-constructed portfolio becomes heavily weighted toward the well-performing asset. Investors who don’t rebalance may find themselves overexposed to rich asset classes and underexposed to cheap ones.

2. Behavior biases – Often, even the smartest investors will make emotional or irrational decisions when it comes to choosing assets. Investors will allocate capital to assets that have performed well, in hopes the asset will continue performing. Emotional decisions can also cause investors to sell asset classes when their markets have declined. Emotional views of performance do not constitute well-reasoned investment opinions. Left unchecked, these decisions can affect allocations and potentially harm performance. 1

3. Unbalanced Income Reinvestment - Investors sometimes reinvest income produced by a specific investment product back into that same product. While reinvesting income within the portfolio can build more value more effectively than distributing the income, it skews weights toward classes with greater income-generation potential.

A key to addressing these issues is an annual rebalance of your portfolio. Rebalancing portfolios annually may not only generate additional return potential, it can lower volatility versus never rebalancing.

Rebalancing Can Harvest Value from Volatility

Over the very long term, and with a yearly rebalancing regime, recent work2 has shown how volatility can be “harvested” to help build wealth. The interactive chart below shows two long-term constructions of domestic stock and bond portfolios of different mixes. If you look at their values after 20-plus years, you’ll see that the rebalanced version has significantly outperformed the version that was not rebalanced. In addition, a 60% stocks/40% bonds portfolio rebalanced annually has actually outperformed a static 100% stock portfolio.

Regular Rebalancing Has Historically Bolstered Investment Returns

Note: Returns for stocks are based on the S&P 500 Index. For bonds, the Barclays US Aggregate Bond Index. Starting value $100, Jan. 1, 1977 through Dec. 31, 2014.
Source: Bloomberg, Morgan Stanley Wealth Management GIC as of Dec. 31, 2014

How can this modest amount of rebalancing create such significant value? Rebalancing takes advantage of the long-term effects of mean reversion. By lightening up on stocks after periods of significant outperformance, or topping off positions after periods of underperformance, this discipline helps take advantage of volatility to benefit from these swings.

It’s important to note that this method of rebalancing does not require any insight over which asset class will outperform in any given period—only that a disciplined approach dictates a fixed mix of portfolio assets, as well as a set interval during which rebalancing takes place.

The potential benefits from rebalancing also extend beyond improved returns. As you can see in the interactive chart below, historically, annual rebalancing has actually lowered portfolio volatility.

Annual Rebalancing Has Muted Portfolio Volatility

Note: Returns for stocks are based on the S&P 500 Index. For bonds, the Barclays US Aggregate Bond Index. Stock/Bond Portfolios With and Without Annual Rebalancing Jan. 1, 1977 Through Dec. 31, 2014.
Source: Bloomberg, Morgan Stanley Wealth Management GIC as of Dec. 31, 2014.

While this may seem surprising, it makes sense if you consider that, over time, a portfolio can significantly stray from its initial allocation. We examined this phenomenon over recent history. We initiated a 60% stock/40% bond portfolio beginning in 1977, and let the portfolio grow with no rebalancing. As you can see below, the sample portfolio would have been both overweight equities—having an allocation greater than 60%—despite the fact that the asset class was generally more expensive than long-term history.

Without Rebalancing, Portfolios Have Been Overweight Equities at Market Tops

Note: Stocks are represented by the S&P 500 Index; bonds are represented by the Barclays US Aggregate Bond Index. 60% Equity/40% Bond Portfolio. Source: Bloomberg, Morgan Stanley Wealth Management GIC as of June 30, 2015

Conversely, prior to market tops, the sample portfolio was generally underweight equities despite the asset class’ attractive valuation. In each of these cases, rebalancing to establish an allocation closer to target would have helped performance.

Following periods in which an asset class significantly outperforms, portfolios will likely be overweight that asset. Because of this, they will have strayed from the original allocation, which can change the portfolio’s risk profile. Rebalancing back to the original allocation restored the original risk profile and reduced volatility across different stock/bond allocations historically.

Annual rebalancing may also prevent a portfolio from being overweight equities or bonds at the end of a bull market, which would reduce volatility from a correction. It would have also restored the portfolio’s allocation which may help returns.

Invest with Patience and Discipline

A disciplined approach to rebalancing portfolios annually can create additional return and lower volatility versus never rebalancing or rebalancing during different time periods. While investing for the long term requires patience, a disciplined approach to rebalancing can help create value beyond the cyclical trends of the market.

Staying on course is paramount; but beyond asset allocation, there are many resources to aid in the other aspects of portfolio construction. When choosing specific investments, Morgan Stanley Wealth Management offers guidance in selecting managers, as well as individual stocks and bonds. At a higher level, Financial Advisors can form relationships with clients to better understand their financial needs and goals. This would encourage portfolio construction that is consistent with client goals, yet maintains acceptable levels of risk.

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