DOES REBALANCING BOOST RETURNS?
“Rebalancing” is on the lips of every wealth manager. It’s one of the things they do to justify
their fees. It’s supposed to make you richer.
Rebalancing is the art of taking money from winning investments, at regular intervals, and
redeploying it into losers. The technique usually is applied to categories of investments (as
opposed to individual securities): You keep a certain balance between, say, growth stocks and
value stocks or between stocks and bonds. By this discipline you are induced to sell high and
buy low, or so goes the theory.
Burton Malkiel, the Princeton economist and advisor to Rebalance IRA, explains how the
system would have worked over the past 15 years.
“It’s January 2000. You have no idea that this is the top of the Internet bubble. But you do
know that your 60/40 allocation is now 75% stocks and 25% bonds. So you sell stocks and buy
bonds,” he says.
“January 2003: You don’t know that October of [the previous] year was the bottom of the
market for stocks. You do know that the Federal Reserve is getting interest rates closer to zero,
and that your bonds are up to 55% of your portfolio and your stocks are 45%. So you sell bonds
and buy stocks. ...
“The big lesson of behavioral finance is that people do exactly the wrong thing. They came
into the [stock] market in the first quarter of 2000 because high tech was hot. The money came
out in the third quarter of 2008 because the world was falling apart. Rebalancing forces you to
do just the opposite.”
So far into this century rebalancing looks very smart. But is it sure to keep working? Skepti-
cism is called for whenever anyone claims to have in hand a formula that guarantees enhanced
profits.
Yes, rebalancing is a certain winner if you are dealing with two categories that you know, in
advance, will have the same average return.
Suppose stocks and bonds are destined to each earn 5% a year over the next 25 years
while following irregular paths to the finish line. A portfolio that starts out 50/50 and remains
untouched will earn 5% a year. A portfolio that is rebalanced will do better than 5%. Just as
advertised, rebalancing will have you getting out of stocks when they are ahead of themselves
and into relatively cheap bonds, and vice versa.
The catch is that you have no way of knowing that stocks and bonds are going to deliver the
same average return. From 1942–67 stocks raced ahead. An undisturbed portfolio that started
out 50/50 ended up with a heavy stock allocation and an average return of 8.6% a year. A
rebalancer would have been pulling money out of the stock market and would have ended with
only 5.5% a year.
Rebalancing is also bad news in a relentless bear market. If U.S. stocks sink into a 25-year
funk, a rebalancer will be averaging down and getting killed.
Michael Nolan, an analyst at the Bogle Financial Markets Research Center, looked at 25-year
returns for hypothetical stock/bond portfolios over the past two centuries. The chart displays
the benefit (or loss) produced by rebalancing over the return enjoyed by someone who started
out 50/50 and then stood pat.
Rebalancing adds to wealth just some of the time. On average, Nolan found, rebalancing
subtracted an annual 0.15% from results. — W.B.