David Stevenson: A rebalancing act without thrills and spills

Over the next few weeks, I’m going to combine my usual selection of adventurous investments with some practical tips on what “works” for those who manage their own portfolios. And I’m going to start with rebalancing a portfolio of diverse assets.

Rebalancing is hugely important because it controls risk. Investors tend to let rising asset prices keep on rising. However, in reality, few of us can be sure when prices will crash and destroy the value of our portfolios.

For this reason, US commentators Paul Merriman and Richard Buck believe that investors should always rebalance. In a paper entitled “One portfolio for life?”, they say: “To maintain the proper amount of risk, you should keep the portfolio within reasonable distance of its… target allocation.”

To explain why, the authors studied a hypothetical portfolio that started out in 1990 as 60 per cent US equities and 40 per cent bonds. By the end of 1999, without any rebalancing, the equity allocation had grown to 78 per cent, with bonds making up only 22 per cent. As long as equities were doing well, this was a profitable approach. But we all know what happened in the following two years.

If that same portfolio had been rebalanced annually instead, the losses incurred between 2000 and 2002 would have been cut from 22.2 per cent to 12.6 per cent.

Vanguard, the US fund management company, has also weighed into this debate, concluding that: “If a portfolio is never rebalanced, it will gradually drift from its target asset allocation to higher-return, higher-risk assets.” Vanguard’s researchers looked at the same 60:40 equity:bond split and concluded that the portfolio’s allocation would gradually drift towards a 90:10 equity bias, because of the historical outperformance of shares.

Another couple of investors take a radically different view. Financial pundits Phil DeMuth and Ben Stein suggest an approach called “per-cent-based tolerance limits”. They argue that rigid annual rebalancing is a mug’s game. In their book, Yes, You Can Supercharge Your Portfolio, they say: “Although it can incur tax and transaction costs, rebalancing is promoted on the idea that it gets us into a righteous ‘sell high, buy low’ discipline.”

But, rather than accept this conventional wisdom, Stein and DeMuth put it to the test. They also used a 60:40 equity:bond split but then looked at 10,000 simulations involving complex portfolios based on seven asset classes. They experimented with all manner of strategies but concluded that “the more frequently we rebalance, the worse our returns”.

Their study suggests that the most successful approach is a 20 per cent tolerance limit. To understand how this works, imagine that an asset class represents 40 per cent of a portfolio and you have a 20 per cent tolerance limit. You would rebalance back to the original 40 per cent allocation only when the value of that asset rises or falls by more than 20 per cent – in other words, when it represents more than 48 per cent, or less than 32 per cent, of the overall portfolio.

Academic turned portfolio software guru Gobind Daryanani agrees with this tolerance approach. In his view, with annual rebalancing, “the dates chosen... are arbitrary, and thus we cannot possibly expect to catch the juiciest buy-low/sell-high opportunities”.

Legendary US fund manager and shareholder champion John Bogle has also tried to find the best solution. He calculates that a portfolio consisting of 48 per cent S&P 500 shares, 16 per cent small-cap shares, 16 per cent international shares and 20 per cent in a bond index tracker would have achieved a 9.49 per cent annual return without rebalancing, or a 9.71 per cent return if rebalanced annually. That tiny difference, claims Bogle, is “noise”, and suggests that formulaic rebalancing is not necessary.

He even cites an earlier study of all 25-year periods since 1826, using a 50:50 split US equity:bond portfolio. This found that “annual rebalancing won in 52 per cent of the 179 periods”. Bogle’s conclusion? “Rebalancing is a personal choice, not a choice that statistics can validate.”

Fund manager Rob Arnott argues that is a choice worth making. All that matters, he says, is that you rebalance in some way. He recently told me: “Whatever approach you use, whether you do it monthly or quarterly or annually or based on 10 per cent market moves, or 20 per cent market moves... doesn’t matter.

“Our studies suggested that, on a risk-adjusted basis, the rebalancing returns are all within a tenth of a per cent of one another, regardless of what method you use. But the act of rebalancing, no matter how you do it, is worth about a half a per cent for domestic [US] portfolios and about a per cent and a quarter for global portfolios. If you do 1 per cent a year better for the 40 years of your career, you’ll be retiring on 40 per cent more wealth.”

So his message is clear: rebalance or retire poor! You can listen to my audio interview with him at www.ft.com/moneyshow.