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.

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.