Does Portfolio Rebalancing Work?

Running my own SMSF and always on the lookout for different ideas to help maximise returns and read an article on re balancing, that is every 3 months or whatever time frame you choose you re balance your portfolio, so say you want 50% shares, 40% bonds and 10% property at the end of each quarter you have had a good run in shares and your now 60% shares, 35% bonds, 5% property, you sell 10% of your shares and buy 5% each in bonds and property to get your allocation back to its desired risk level.

In many ways it seems to me this forces you to sell high and buy low, does anyone run there super/investments in this way and how often would a rebalance take place, also what are the pros and cons and most importantly does it work?

It works. It works across and within asset classes. It works because you are 'harvesting' the volatility of markets. Prices zig and zag. If you do not rebalance, you have zero probability of participating in a situation where sequential moves are in opposing directions. Rebalancing allows you to capture it. The more volatile the assets are and the less correlated, the bigger your rebalancing profits are going to be. And these can be very meaningful. Further, it's not as if you need to be an investment genius to do it. The key question is whether transaction costs exceed the rebalancing profit expectation.

Instead of going through the maths for that, which gets into thermonuclear equations, just rebalance each six months or year and that'll do you.

Congratulations, you've probably added 0.5% or more to your returns each year. Compound that up for 20 to 30 years and you've just found a way to materially add to your expected wealth.

Disclaimer: This is not advice. It is...entertainment. Do your own work. I do not know your circumstances.

Panaman, the option I've used for many years is to simply let my profits run and cut losers short quickly.
If that means an 'unbalanced' p/f I'm quite OK with that. Have never seen the point in diversification for the sake of it.

Also be willing to switch asset classes when appropriate. You have a SMSF which gives you the complete freedom to do this. If property, e.g., is outperforming shares at a given time, then you could consider switching. With the all the chaos and uncertainty when the GFC occurred, there were some excellent cash options available.

Do what works for you. Don't be unnecessarily confused by admonitions that there is only one correct way.
Good luck.

Julia said:

Have never seen the point in diversification for the sake of it.

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Me neither. And I think unless you're running a $20b pension fund, academic discussions about rebalancing to generate alpha are just that. One thing the private investor has to their advantage is size. There's plenty of low hanging fruit (whether you approach the market technically or fundamentally) so that, IMO, is where the private investor should devote their energy.

McLovin said:

I think unless you're running a $20b pension fund, academic discussions about rebalancing to generate alpha are just that. One thing the private investor has to their advantage is size. There's plenty of low hanging fruit (whether you approach the market technically or fundamentally) so that, IMO, is where the private investor should devote their energy.

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Rebalancing the asset allocation of your portfolio is easily achieved at retail size as well as insto. Admittedly, managing stock portfolios is more challenging for small sized portfolios. It depends on your motivation and your edge. Net results for retail, despite implementation advantages you mention, are uniformly woeful all over the place. Here is a method which basically works. There's no trick or magic to it. It's unexciting. But, it provides an edge that totally overwhelms the average outcome given time. As usual, 80-90% will think themselves above the odds and...let's say...add volatility and liquidity to the market for others to collect. Fantastic.

Presumably, the initiator of this thread has a long term neutral view of what their asset allocation should be. They clearly are aware that drift in the actual allocations will result in portfolio risk which is inconsistent with their aims. In the absence of some insight....is rebalancing so stupid or worthless? As for being academic, I guess a couple of $100bn run this way explicitly and growing like a weed might give you reason to consider the possibility that it has escaped from the labs, actually seen sunlight and probably even had a date! You can even buy ETFs and unit trusts making them directly accessible to those with less than $20bn.

Overall, it's just an idea. One of many in this ocean to choose from. But it works. There is no other free lunch available in investments other than diversification if you intend to stay out of prison. Why not take 5 minutes to eat it. You could do a lot worse, and most will despite what they think up front. Many will think the size of the advantage is small and think they can do much better. Take a class photo....and let's see where they are in the 10 year reunion. You know already know what the outcomes are going to be in aggregate, you just don't know who will fill which slot on either side of the line...and everyone thought they'd be on the right side of it at the outset.

Can you be bothered implementing it? Is it worth your time? Perhaps that's what you mean. I think it's worth it for asset allocation. That's easy. Perhaps the original question should be phrased 'given the profits available from rebalancing your asset allocation, and the ease with which it is achieved, why wouldn't you rebalance ?'. You can achieve it in 5 mins. A couple of phone calls or click-through futures trades. Leaving plenty of time for other investment activity. If your profit per minute could be sustained at this level, your wealth would exceed $20bn before too long. Would you regard that as a poor allocation of time? Surely not.

Cheers.

Disclaimer: This is not advice. I do not know your circumstances. Please do your own work. I am not endorsing any ETF or unit trust.

Julia said:

Panaman, the option I've used for many years is to simply let my profits run and cut losers short quickly.
If that means an 'unbalanced' p/f I'm quite OK with that. Have never seen the point in diversification for the sake of it.

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Pretty much the same here, although I'm a bit more patient with the losers if the business remains sound and it's just a case or me buying in too early. I guess that depends on how you define a "loser".

Also be willing to switch asset classes when appropriate. You have a SMSF which gives you the complete freedom to do this. If property, e.g., is outperforming shares at a given time, then you could consider switching. With the all the chaos and uncertainty when the GFC occurred, there were some excellent cash options available.

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I think one big mistake that many make is to assume that average conditions always apply. Eg stocks outperform cash over the long term, therefore they assume they need to be in stocks right now even though the market's heading down and banks are paying 10% interest (hypothetical example).

DeepState said:

Rebalancing the asset allocation of your portfolio is easily achieved at retail size as well as insto.

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Actually, I meant unless you're an insto, who by virtue of size has a much harder time trying to beat the market, there are much easier ways to juice much more than 0.2% (Is that pre or post tax?).

McLovin said:

Actually, I meant unless you're an insto, who by virtue of size has a much harder time trying to beat the market, there are much easier ways to juice much more than 0.2% (Is that pre or post tax?).

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Hi McLovin

Nicely worded. That 0.2% is pre tax [you were referring to the four bank example from SMURF1976 in a different thread? In rebal to SAA correlations are lower and the gain is higher depending on what you are rebalancing]. In an SMSF, you keep a lot of it. If you have easier ways to juice the market, you should do it. But it would need to be something out of this world not to spend 5 mins rebalancing each 6 months to achieve that outcome in equivalent time. Then, after you've deployed 5 minutes, juice away.

Insto also works at lots of things to juice their portfolios and has tricks up sleeves to manage t-cost that I'm not sure you fully appreciate. The median insto manager in Australian equities large cap beats the index by about 1-2%. The retail investor, with virtually no market impact (but higher bro) gets about -2%. Perhaps your extrapolations on insto performance and retail need to consider more factors than t-cost. Yet insto does this because it is simple and it works. Not from desperation. Insto knows not to leave money on the table. They do it for AUM well below $1bn too.

But, hey, maybe it's "whatever". To me, the power of compound interest is serious stuff and a little here and a little there over time makes a very big difference. Most people don't appreciate it, preferring bright lights and the promise of big returns. It's a cognitive bias that you can check for by sticking someone's head into an fMRI machine and seeing which parts of their brain light up when giving them the choice of a boring 0.5% per annum and some hot idea. Naturally, it costs them money. In the field of behavioural finance, it is known as the Lottery Effect.

Rebal is just one piece of building and maintaining portfolios. It comes with low governance requirement and execution load. It's not as if I or insto ignores the opportunity to juice it up beyond that. And some of that is truly staggering stuff - juicing entire dumpsters at a time. With only 10 minutes a year on rebalancing....there are 365days-10mins available to hunt elsewhere each year.

If it's not for you...no worries. Just an idea.

Here's a 20-year return matrix.

Do some analysis and see if rebalance gives you an edge.

http://www.bullionvault.com/US_Annual_asset_performance_comparison_1973-2013.pdf

Panaman said:

Running my own SMSF and always on the lookout for different ideas to help maximise returns and read an article on re balancing, that is every 3 months or whatever time frame you choose you re balance your portfolio, so say you want 50% shares, 40% bonds and 10% property at the end of each quarter you have had a good run in shares and your now 60% shares, 35% bonds, 5% property, you sell 10% of your shares and buy 5% each in bonds and property to get your allocation back to its desired risk level.

In many ways it seems to me this forces you to sell high and buy low, does anyone run there super/investments in this way and how often would a rebalance take place, also what are the pros and cons and most importantly does it work?

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Careful you don't "cut the flowers and watering the weed" - Peter Lynch.

i personally don't diversify for the sake of diversification. I put all mine in stocks and diversify within that... it sounds risky but it'd be riskier doing things i don't know.

Also, given the current low interest rate, why would you want to lend money through buying bonds? Or the high property market, why you would go out and buy property now?

Through stocks, you can diversify into these other assets... e.g. buy a property developer like Australand or stockland

Do what works for you.. Forget all these academics and theory
Most don't work in real world for retail investor.

Retail investors has plenty of advantages that only experience
tell you.... It doesn't covered in theory or academic paper.

ROE said:

Do what works for you.. Forget all these academics and theory
Most don't work in real world for retail investor.

Retail investors has plenty of advantages that only experience
tell you.... It doesn't covered in theory or academic paper.

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Agreed...do what works for you.

Disagree...the rest.

We are all self taught. How each of us learns is unique, but it seems rather limiting to dismiss a body of massive effort on the grounds that most don't work. Strangely, most investment strategies attempted don't work either. Should we advocate dismissing all of that too on the grounds that most of them don't work in the real world?

As a practitioner who was privileged/suffered intense learning in the cauldron of the real world and really big money we sought out every advantage we could find. We weren't too proud of where it came from. I even read a few academic journals and found some to be informative and some to be very useful in developing my world view. I worked with some ex-academics and worked with some street animals. Both were a fruitful source of learning.

Investments is about getting to the truth faster than the next guy. It doesn't seem advisable to cut off a major source of potential advantage with a hand wave.

Given the context of this thread and this pushback, let's search for truth.

The question was: Does rebalancing add value?
The answer, in my opinion, is YES.
Should you disagree, please point out where the error is in the equations and logic scattered all over the place. I will make you famous and rich.

Is this idea academic? Let's see.
The idea was developed by a guy called ER Fernholz. An academic? He developed it whilst working on an FX desk at a major bank. The firm he went on to found has around $50bn in AUM now.
It was further developed by David Booth. An academic? No, not really. He utilized these techniques to build a monster firm, made himself a billionaire and then gave a couple of hundred million to Chicago Business School to thank them for the lessons he learned - from academics - that he used to make him rich. It was the largest corporate donation in US history. That's why Chicaco Business School is known as Chicago Booth.
It's now applied to more than $300bn world wide on a pure basis...seemingly thriving in the real world.

RoE, you have indicated that you use a dividend screen as a key part to your analysis. This was brought to the public by Fisher Black, then an academic, in 1976. If you read some academic stuff, it might have lessened the cost or duration of your education - unless you pre-dated this. Fisher Black would probably have won a Nobel but has his life cut short. He left academia and ended up as an MD at Goldman. Escaped to the real world. That said, well done on coming to this conclusion. There is merit.

Apart from the impost of market impact from trading, I would be curious as to what things are available to retail which are somehow not available to insto and how you could be so confident they aren't contained in something that someone in the world has researched and maybe put into writing for the public to examine and develop from? Making a claim that you are smarter than all of academia is rather a large statement - even if, hypothetically, 95% might be numbskulls.

Whilst everyone is free to pursue life as they see fit and invest as they see fit (short of joining SAC Capital), it seems rather limiting to exclude swathes of thinking from any source in a competition for truth.

In any case, this rebal stuff was invented and implemented by people outside of the academy. Do what feels right to you, but make an informed choice.


Disclaimer: I do not take responsibility for the work of David Both or Fernholz, or necessarily endorse them individually. This is not advice. Please do your own work.

Victorious warriors seek to win first then go to war, whilst defeated warriors seek war first and then seek to win. - Sun Tzu

If I can see further it is by standing on the shoulders of giants. - Isaac Newton

Rebalancing, diversification across asset classes are only useful and profitable if it's done for the right reason. Most often it's just done so it spread the risk of one asset class going down and fund managers not getting any bonuses for the year, or it's advised so your financial planners get a fee and their sponsors get more commissions.

Let say your business is construction and infrastructure engineering, and just so your business is diversified, a hired consultant tells you to get into bio technology or financial management.

You might be able to do it, but chances are it's riskier than doing what you know, explore opportunities your current operations could build on.

But say you have the knowledge, the money, the opportunities... and having x% already in stocks, you could no longer find any opportunities offering a higher possible return than this bonds offering, or this foreign currency opportunity...and you know, with reasonably good chances, that you'll make higher return in other asset classes, then yea, take it.

But to simply rebalance and diversify to spread the risk... I think often it's to spread the risk of the advisers and managers getting it wrong than anything beneficial for the client.

You don't see a brain surgeon going to plumbing school in case the surgery business get a bit slow sometime.

---
Didn't one of the Black Schole guy programmed the systems for Long Term Capital Management, losing billions and almost bring down the world's financial system?


I think that quote from Newton was made to insult this other guy who claimed Newton copied his works, the guy being short, Newton said if i can see further, it's because i stand on the shoulders of giants, not a midget like yourself. Good quote though.

The other Sun Tzu quote is also good: the ability of an army to move depends on intelligence (inside knowledge). Too bad it's illegal.

luutzu said:

Rebalancing, diversification across asset classes are only useful and profitable if it's done for the right reason. Most often it's just done so it spread the risk of one asset class going down and fund managers not getting any bonuses for the year, or it's advised so your financial planners get a fee and their sponsors get more commissions.

Let say your business is construction and infrastructure engineering, and just so your business is diversified, a hired consultant tells you to get into bio technology or financial management.

You might be able to do it, but chances are it's riskier than doing what you know, explore opportunities your current operations could build on.

But say you have the knowledge, the money, the opportunities... and having x% already in stocks, you could no longer find any opportunities offering a higher possible return than this bonds offering, or this foreign currency opportunity...and you know, with reasonably good chances, that you'll make higher return in other asset classes, then yea, take it.

But to simply rebalance and diversify to spread the risk... I think often it's to spread the risk of the advisers and managers getting it wrong than anything beneficial for the client.

You don't see a brain surgeon going to plumbing school in case the surgery business get a bit slow sometime.

---
Didn't one of the Black Schole guy programmed the systems for Long Term Capital Management, losing billions and almost bring down the world's financial system?


I think that quote from Newton was made to insult this other guy who claimed Newton copied his works, the guy being short, Newton said if i can see further, it's because i stand on the shoulders of giants, not a midget like yourself. Good quote though.

The other Sun Tzu quote is also good: the ability of an army to move depends on intelligence (inside knowledge). Too bad it's illegal.

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I really enjoy your writing and ideas. Please keep going.

I have sympathy for your views on over diversification and agency conflict. They are very reasonable and what you are saying does go on. In this thread, the question was about rebalancing across existing asset classes. Panaman is already in the asset classes and talking about relatively small moves. If Panaman is asking these questions, I imagine that he is somehow capable of making this decision and hence it is relatively free of the agency risks you are referring to.

It was Scholes and Merton who worked in LTCM. Together with Black, they invented the Black-Scholes-Merton model for options pricing. Black-Scholes invented it first and then Merton found a simpler way to do it. So now they all share ownership. It remains in use today as the primary tool for options pricing.

Hahaha on Newton...I did not know that. That's fantastic.

Yeah, don't do inside info or stock manipulation. I know people who have gone to jail for it. Very very naughty. I feel bad for their families.

Take care.

DeepState said:

It works. It works across and within asset classes. It works because you are 'harvesting' the volatility of markets. Prices zig and zag. If you do not rebalance, you have zero probability of participating in a situation where sequential moves are in opposing directions. Rebalancing allows you to capture it. The more volatile the assets are and the less correlated, the bigger your rebalancing profits are going to be. And these can be very meaningful. Further, it's not as if you need to be an investment genius to do it. The key question is whether transaction costs exceed the rebalancing profit expectation.

Instead of going through the maths for that, which gets into thermonuclear equations, just rebalance each six months or year and that'll do you.

Congratulations, you've probably added 0.5% or more to your returns each year. Compound that up for 20 to 30 years and you've just found a way to materially add to your expected wealth.

Disclaimer: This is not advice. It is...entertainment. Do your own work. I do not know your circumstances.

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If I sell shares I bought in July 2013 in Jun 2014, I end up paying almost 50% in CGT on this rebalance... is it still worth it?

If I sell in July 2014 I end up paying almost 25% in CGT on this rebalance... is it still worth it?

Can't see how it is worthwhile unless your are in tax-free pension mode.

TPI,

Rebalancing, from some limited research, within the category of shares, will only work with a group of shares going up in price.

If the portfolio includes shares that go down in price and stay down (or go bust) then underperformance can be expected. Another weakness with rebalancing is that it cuts the big winners off at the knees. For the longer term portfolio, 1 or 2 shares that are multibaggers are often the basis for a large percentage of the overall gain.

If you take small gains off these and cut the number of shares in the winners, while adding to losers, the long term result is certain, loss and underperformance. Only if the losers turn around can the system work. The assumption of returning to the mean will work most of the time with fundamentally sound companies, it is the times that it doesn't work that will destroy the portfoilio in the long term.

I still can't find a system that is better than simple buy, add to winners, cull losers quickly. Simple to say, simple to understand, very hard to do for most.

brty said:

I still can't find a system that is better than simple buy, add to winners, cull losers quickly. Simple to say, simple to understand, very hard to do for most.

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Agree, though I think that this can be done either with a trader's approach or a long-term investing approach, where the long-term investor culls losers not based on short-term changes in share price but on known and fundamental changes to the quality of the underlying business, the sustainability of its earnings and future dividend payments.

Something occurred to me today...to keep it simple lets look at a 2 stock, 10K portfolio.

With Rebalancing

$5000 of ABC stock and $5000 of XYZ stock, 1 year passes and ABC has gone up 50% ($7500) and XYZ has gone down 50% ($2500) and we rebalance taking $2500 out of ABC and buying $2500 worth of XYZ so we are back to $5000 of each, 1 year passes and both stocks have gone up 50% so we now have $15000 worth of stock.



--------------

With NO rebalancing

$5000 of ABC stock and $5000 of XYZ stock, 1 year passes and ABC has gone up 50% ($7500) and XYZ has gone down 50% ($2500) and we do nothing, 1 year passes and both stocks have gone up 50% ~ our ABC stock is now worth $11250 and our XYZ stock is now worth $3750 so we now have $15000 worth of stock.

:dunno:

Did i miss something?

So-Cynical,

Yes you did miss something.

The $2500 gain on ABC in the first year is taxable, so at the 30% tax rate thats $750, plus 2 lots of transaction fees extra. Net result, worse off with rebalancing.

See what happens to your 2 stock portfolio if ABC goes up 50%/a for 5 years and XYZ goes down 50%/a for 5 years. That's when you see the risk of rebalancing.

So_Cynical said:

:dunno:

Did i miss something?

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Rebalancing isn't printing money, it's just an edge. It has a positive expectancy, but it doesn't mean it will work in all combinations of stocks and return profiles... especially with just 2 stocks over two time periods.

I don't know if this rebalancing bonus is "law of nature" like gravity. However, given that some researcher has done lots of analysis and found that to be the case over their period of observation, then it is likely to be repeatable until there are substantial changes in the behaviour of the stock market and its participants.