Rebalancing your portfolio not only brings your portfolio to target asset allocation but also delivers you extra diversification-return, aka, rebalancing-bonus.
Portfolio rebalancing is the act of selling assets that have appreciated and buying assets that have declined in value relative to the portfolio, such that the capital allocation of each asset becomes aligned with their target portfolio weights.
To use a simple example, imagine you want to build a portfolio that contains two assets SPY and EEM, and you want to allocate $100 each to both ETFs on day 1, which means the portfolio weight for both SPY and EEM is 50%. After a certain amount of time, SPY appreciated 20% while EEM declined by 20%. In this case, your SPY fund grows from $100 to $120, and EEM declines to $80, which makes their portfolios weights to be 60% and 40%, respectively. To bring your portfolio to the target weights of 50%-50%, you need to sell $20 of SPY and use that profit to buy $20 worth of EEM, assuming no transaction cost.
From this much-simplified example, you can see two facts:
Rebalancing your portfolio leads to realized profits and losses
Rebalancing enables you to buy low and sell high by its nature
Both of these simple facts have important implications, as we will see later.
Reason 1: Rebalancing Is Needed To Keep Your Portfolio At Desired Risk Profile And Diversified
The moment you select a group of assets and decide an asset allocation for them, you have defined the risk-reward for this particular portfolio – one that you believed is optimal for that moment. Hence, unless you received new information that instructs you to make a change to the allocations, you should stick to the original optimal asset weights, and that requires you to rebalance the portfolio if it deviates the optimal weights, otherwise, the new risk-reward profile will steer to unexpected regions.
Let’s illustrate with again a simple example. Suppose you initially invest in a portfolio with 90% allocated to AGG(a bond ETF), and 10% allocated to SPY(US equity ETF). The risk profile(i.e., risk allocation, or risk attribution)[1] of this portfolio is roughly 80% from AGG and 20% from SPY. Put in layman’s terms, if you put down $90 on AGG and $10 on SPY, over the long term, SPY can explain about 20% of the fluctuations if your portfolio values while AGG can explain about 80% of them.
Now imagine a year later AGG delivered 5% of total return while SPY delivered 67%(unrealistic? check their performances during Covid pandemic and you will see what I mean), which brings the capital weight of AGG to be 85%, and SPY to be 15% in the portfolio. Now, what happens to their risk profile?
You will find that SPY now accounts for 33% of the risk profile of your portfolio with AGG 67%. What just happened is that a capital weight move of 5%(90% -> 85% for AGG, and 10% -> 15% for SPY) resulted in a 13% move of risk profile(80% -> 67% for AGG, and 20% -> 33% for SPY).
In this scenario, the risk profile of your portfolio moved way ahead of its capital weight profile. If you have been using capital weight deviation as criteria for your rebalancing, perhaps you need to rethink it and consider using risk profile deviation as well.
Reason 2: You Get Bonus By Rebalancing Your Portfolio, That is, Rebalancing-Bonus
You can get positive portfolio returns even if each asset has a net-zero return, just by rebalancing the portfolio.
How could this happen? Let’s start with a simple example, and get into more intuitive explanations in a bit.
Consider two assets X and Y, and two time periods T1, and T2. Let’s look at the following scenario:
At the beginning of period T1, asset X has a price of $100, and at the end of T1, it appreciated by 25% to have a price of $125. Then in period T2, it lost 20%, which ends up with a price of $100.
Asset Y behaves the opposite: it starts with a price of $100 at beginning of T1, but then lost 20% of its value and is priced at $80 at end of T1. Then in T2, it appreciated by 25%, which ends up also with a price of $100
In this scenario, both asset X and Y have a net return of 0 percent, even though they experience opposite directions of price movement during the two periods.
Suppose you invested $100 each in X and Y at the beginning of period T1. If you are a buy and hold you will end up with a $200 total portfolio value at the end of period T2, i.e., net 0 return.
However, if you rebalance at the end of period T1, you will end up with a portfolio value of $210.125 at the end of period T2, a total return of 5.0625%!!! How? Let’s work out the calculation in two steps:
Step 1, since asset X appreciates to $125, while Y declines to $80 at end of T1, to rebalance to the original 50%-%50 portfolio, you need to sell $22.5 of X and use this profit to buy $22.5 of Y, and you end up with $102.5 for both X and Y after rebalancing.
Step 2, during period T2, asset X declines by 20%, so your holding value of the asset of X declines from $102.5 to $82. On the other hand, asset Y appreciates 25%, so your holding value of asset Y goes from $102.5 to $128.125. As a result, your total portfolio value is now $210.125, which means your total portfolio return is 5.0625%(=$210.125/$200 – 1), and that is your rebalancing bonus!
An Empirical Explanation of Rebalancing-Bonus
As we laid out at the beginning of this article, you are buying low and selling high in the process of rebalancing. By repeating this process you keep locking the profit from an asset that appreciated value while investing in assets that potential are undervalued.
For a more technical explanation, you can refer to paper [2] where you will find that the rebalancing bonus can be estimated by a portfolio diversification measure:
Based on this equation, rebalancing-bonus depends on two things:
the volatility of the underlying asset
correlations among those assets
how diversified your portfolio is, which depends on how you construct your portfolio
A Pitfall For Taxable Accounts: Watch Out For Wash Sales
A wash sale is a sale of a security (stocks, bonds, options) at a loss and a repurchase of the same or substantially identical security (judging by CUSIP or Committee on Uniform Securities Identification Procedures numbers) shortly before or after. Losses from such sales are not deductible in most cases under the Internal Revenue Code in the United States.[3][4]
If you rebalance your portfolio too often, you will be realizing your profits and losses, and you could end up with lots of buys and sell trades for the same asset, and if the timing of these trades is too close to each other, you could be hit by wash sales and end up with non-deductible losses.
To conclude, rebalancing your portfolio is necessary since it allows you to keep the risk profile of your portfolio under control, and it delivers you a rebalancing bonus compared to buy-and-hold.
Reference
[1] https://en.wikipedia.org/wiki/Risk_parity
[2] Willenbrock, Scott, Diversification Return, Portfolio Rebalancing, and the Commodity Return Puzzle (December 1, 2010). Financial Analysts Journal, Vol. 67, No. 4, pp. 42-49, July/August 2011, Available at SSRN: https://ssrn.com/abstract=1898864
[3] https://en.wikipedia.org/wiki/Wash_sale
[4] https://www.irs.gov/publications/p550#en_US_2020_publink100010601