Does Rebalancing Boost Returns?

March 7, 2011

Rebalancing your portfolio has two potential benefits. The first is that it helps control risk by keeping your asset allocation more or less consistent. The other advantage—assuming you have the discipline to pull the trigger—is that it encourages you to sell high and buy low. In theory, that should lead to higher returns over the long run. But does it work in practice?

In a recent article for Canadian MoneySaver, I set out to learn how things would have worked out for investors who religiously rebalanced a traditional Couch Potato portfolio over the last 20 years. I would have preferred to use real performance data, but that was impossible, since no Canadian index funds or ETFs have a track record going back that far. So I ran the numbers using two decades of historical index data.

I assumed that two investors—let’s call them Norman and Reba—started on January 1, 1991, with $10,000 in a portfolio of 20% Canadian equities, 20% US equities, 20% international equities and 40% Canadian bonds. Norman never touched his portfolio for 20 years, while Reba rebalanced back to these target allocations annually on January 1.

Who came out ahead?

The table below shows what their portfolios would have looked like on December 31 of each year. The percentage in the last column indicates how much larger (or, in the case of a negative number, smaller) Reba’s portfolio would have been because of her rebalancing strategy.

Norman Reba
(never (annually Rebalancing
rebalanced) rebalanced) advantage
1991 $11,962 $11,962 0.00%
1992 $12,820 $12,766 -0.42%
1993 $15,785 $15,865 0.51%
1994 $16,209 $16,287 0.48%
1995 $19,463 $19,490 0.14%
1996 $22,763 $22,740 -0.10%
1997 $26,911 $26,374 -2.00%
1998 $32,191 $30,784 -4.37%
1999 $36,378 $34,675 -4.68%
2000 $36,380 $35,480 -2.48%
2001 $34,598 $34,124 -1.37%
2002 $31,293 $31,783 1.57%
2003 $34,673 $35,616 2.72%
2004 $37,428 $38,708 3.42%
2005 $40,895 $42,494 3.91%
2006 $46,381 $48,324 4.19%
2007 $46,460 $48,507 4.41%
2008 $38,972 $41,444 6.34%
2009 $44,245 $47,188 6.65%
2010 $48,307 $51,104 5.79%

Does rebalancing enhance returns?

So, did Reba’s annual rebalancing lead to higher returns? If we go right to the bottom row in the table, the answer seems to be yes. Reba’s portfolio has 5.79% more money than Norman’s. Over the full 20-year period, the annualized returns work out to 8.2% for Norman and 8.5% for Reba. An extra 30 basis points compounded over the long term is a significant benefit.

However, rebalancing did not enhance returns over every time frame. At the end of 1995 and 1996, the portfolios were virtually neck-and-neck, and over the next six years, Norman pulled ahead by a considerable margin. His high point came just before the dot-com bubble burst in early 2000, when Norman’s account was about 5% larger. Reba did not regain the lead until 2002, but since that time she’s stayed out in front, peaking in 2009 when her portfolio was almost 7% larger.

Rebalancing can also lower returns

These results show that there are times when rebalancing a portfolio will lead to lower returns for several years running. This is most likely to happen during prolonged trends, which explains why Norman outperformed during the relentless bull market of the mid- to late 1990s. Rebalancing during this period would have meant continually taking money out of soaring equities and pouring it into lagging bonds. On the other hand, when bonds and equities are highly uncorrelated and volatile—as they have been since 2008—then rebalancing is more likely to result in higher returns.

It’s worth noting that the period from 1991 through 2010 was rather unusual when measured against historical averages. A 20-year trend of falling interest rates resulted in outstanding bond returns over this period, and a rising loonie gutted foreign equity returns that were low to begin with. As a result of these overlapping trends, bonds actually outperformed a globally diversified portfolio of stocks over the last two decades. This period may have been an unusually good one for the strict rebalancer. Over the next 20 years, if stock and bond returns are closer to their historical norms, rebalancing may not deliver that extra 30 basis points a year.

Norman Reba
(never (rebalanced Rebalancing
rebalanced) annually) advantage
1991 $11,962 $11,962 0.00%
1992 $12,820 $12,766 -0.42%
1993 $15,785 $15,865 0.51%
1994 $16,209 $16,287 0.48%
1995 $19,463 $19,490 0.14%
1996 $22,763 $22,740 -0.10%
1997 $26,911 $26,374 -2.00%
1998 $32,191 $30,784 -4.37%
1999 $36,378 $34,675 -4.68%
2000 $36,380 $35,480 -2.48%
2001 $34,598 $34,124 -1.37%
2002 $31,293 $31,783 1.57%
2003 $34,673 $35,616 2.72%
2004 $37,428 $38,708 3.42%
2005 $40,895 $42,494 3.91%
2006 $46,381 $48,324 4.19%
2007 $46,460 $48,507 4.41%
2008 $38,972 $41,444 6.34%
2009 $44,245 $47,188 6.65%
2010 $48,307 $51,104 5.79%

{ 12 comments… read them below or add one }

Sustainable PF March 7, 2011 at 9:41 am

Interesting analysis CCP.
Does this analysis take into account brokerage fees too?

Simon March 7, 2011 at 9:48 am

Rebalancing doesn’t necessarily translate into extra broker fees. It could be that when Reba made their annual/monthly contributions, she just contributed more or less to areas that were needed in order to achieve the desired AA while rebalancing. Norm’s portfolio would have been static amounts contributed over time.

Therefore, brokerage fees are irrelevant in the scope of this study.

Canadian Couch Potato March 7, 2011 at 9:49 am

@SPF: The analysis uses index returns only, so there’s no provision for fees or taxes (which would be impossible because of the large number of variables). But you are right that if Reba used ETFs in a taxable account, the rebalancing would come at a cost each year.

@Simon: I should clarify that the analysis assumes that no new money is ever added. That said, you are correct that brokerage fees are not necessarily an issue: one could build this portfolio with TD e-Series funds in an RRSP and pay no brokerage fees and no taxes until withdrawal (and earn within about 0.5% of the index returns).

Neil Jain March 7, 2011 at 1:48 pm

Hi Dan!

Good article and analysis on rebalancing! I think it’s important for investors to consider whether it makes sense to rebalance their portfolio.

The other variable is that Norman and Reba may become more conservative (or aggressive) with their holdings depending on age, income stability, risk tolerance and other factors.

And, certainly, as pointed out earlier, both will likely add new money during the 20-year period which would afford the opportunity to rebalance without touching the funds already invested.

Regards,
Neil Jain

MoneySheep March 7, 2011 at 3:38 pm

I don’t rebalance at all. The more your activities, the less your returns. If all investments revert to the mean, there is no needs to rebalance.

As showed by the example, sometimes rebalance is worse (first 10 years), sometimes it is better (last 10 years). Who is to say rebalance the next 10 years won’t be worse?

That said, if an investor “believes” it works, he should do it, so he is satisfied to stay in the market.

Canadian Capitalist March 7, 2011 at 4:46 pm

In general, investors should expect to earn back some of the penalty of investing in low-return assets such as bonds through a rebalancing bonus. There are three variables at play here: returns, volatility and correlation. Yes, bonds typically have lower expected returns than stocks but bonds are also less volatile and have very low correlation with stocks. Whether the last 2 variables are enough to overcome the first and deliver extra returns will depend on the asset allocation and the assumptions made. Someone math-savvy may want to do the calculation for us :)

RJM March 8, 2011 at 8:01 am

Dan, just wondering where you get your data for the different index returns?

Canadian Couch Potato March 8, 2011 at 8:19 am

@RJM: I use the excellent spreadsheet compiled by Norbert Schlenker of Libra Investment Management:
http://www.libra-investments.com/re01.htm

Greg March 8, 2011 at 12:28 pm

Wouldn’t it be unusual for someone to stick with a 60-40 split for a 20 year period? It would have been interesting to see the outcome if each started with a higher allocation of stocks (say 80 or 75%) and over time decreased that to 60% to reflect a possible greater risk taken at the younger age when each started.

larry macdonald March 8, 2011 at 7:07 pm

It would be interesting to see if portfolio returns are affected by how an investor rebalances. Some sell high and buy low, while others just add money to the low asset. As the latter investor is only buying low, would they consequently end up with lower returns? Are they also controlling less for risk since the high priced asset could have climbed into bubble territory?

I also can’t help wondering what it would have felt like for a Japanese investor who rebalanced into Japanese stocks over their decline of the past 25 years or so. Can anything be done to avoid this risk?

Canadian Couch Potato March 8, 2011 at 7:45 pm

@Larry: In the table above, I assumed no money was ever added, so the rebalancing was always selling high and buying low. However, if you instead rebalanced by adding new money, the portfolio’s return in any given year would not change. In both cases, the portfolio’s asset allocation is 60-40 on January 1, so the returns must be the same.

Of course, the actual dollar amount in the portfolios would change a lot. You would have large inflows in years where stocks and bonds moved in dramatically different directions (like 2008), and would add almost now money in years where the two asset classes had similar returns (like 1993). But it would have been useless to compare this situation to Norman’s portfolio, which had no cash inflows.

Re: the Japanese situation, yes, rebalancing would have been pretty disastrous. I really don’t see how one could avoid this risk, however, unless you believe that you can identify a bubble before it bursts!

Open source portfolio March 8, 2011 at 9:32 pm

hmm the difference of $3000 seems pretty insignificant over 20 year period. It’s only a difference in return of about 0.4% or about your ETF management fee.

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