Can you learn from the “rebalancing” trick used by professional investors? Schroders

Such tribulations can undermine the discipline needed to make the regular savings needed to build a nest egg for the future. So how should the long-term investor gain and retain the returns they need?

We think no serious investor can ignore diversification. By building a portfolio of several types of assets, such as equities and bonds, you can increase the odds that at least one of them will be working hard when the others aren’t. But maintaining the necessary diversity of assets is not something that can be left to chance. Our research suggests that the successful investor needs to intervene occasionally to keep the right balance between the different assets they have chosen.

Why is balance so important?

Professionals realised years ago that high returns are often won only at the expense of high risk. In other words, risk is as important as return or, as billionaire investor Warren Buffett put it, “Rule number 1: never lose money. Rule number 2: never forget rule number 1.”

In effect, investors should be prepared to accept lower returns if those returns are more reliable. The problem is that many investors often fail to appreciate the risks they have taken to achieve higher returns. Attaining good “risk-adjusted” returns means maintaining the right proportion of those assets that provide growth, balanced against the right proportion that will provide security.

What happens when there is no rebalancing?

The next step is realise the importance of tweaking a diversified portfolio, known as rebalancing. Say equities make up 75% of a portfolio but then have a good run while other assets languish. That equities portion may end up making up 80% of the portfolio. The idea of rebalancing is that you sell until the equities are back to a 75% portion.

You end up selling assets that have performed well and buying ones that haven’t, which would seem prudent.

We decided to run some scenarios to find out how rebalancing, and not rebalancing, would have affected outcomes – the returns achieved versus the risks taken. We used one of the simplest of diversified portfolios split 60% in shares – to provide the growth – and 40% in bonds – to provide the security. While an investor might start with this division, stockmarket movements mean that it will almost certainly move away from the original “60/40” allocation. We looked at how it would have fared in two 10-year periods, 1990-2000 and 2000-2010, with no intervention.

We found that a 60/40 portfolio in 1990 would have ended up divided 75/25 by 2000. On the other hand, a 60/40 allocation in 2000 would have become 45% equities and 55% bonds by the end of the decade. In both cases, the better-performing asset class came to dominate the portfolio. That may well have worked well in terms of returns, but it would have shifted the risks drastically compared to the original asset allocation.

Why is an unbalanced portfolio more risky?

Seduced by high returns, an investor might be tempted to leave a portfolio of high-performing shares or equity funds to grow. The problem is that they may also end up dangerously exposed. The results can be both painful and swift.

Perhaps the most traumatic illustration was in 1974, when the FTSE All-Share Index fell by more than 70% – very bad news for anyone holding a UK share portfolio. Black Monday in October 1987 wasn’t that great either: by the end of the month, the US Dow Jones Industrial Average was down by 22% and the UK market was off by 26%. In 2008, the year when the credit crunch kicked in, the FTSE 100 index fell by 31%. And although they are more secure than equities, bonds can suffer too: in 1994 unexpected interest rate rises by the US Federal Reserve helped to wipe a cool $1.5 trillion from world bond markets.

It is true that markets do come back from such losses, but it often requires a strong stomach to last the journey. For an investor, not having all your eggs in one basket can both protect your wealth and give you the confidence to stay aboard.

How does rebalancing work?

The main rebalancing approaches are either “periodic”, based on set time intervals such as every quarter, or when differences in performance cause the asset allocation to drift away from its target by more than a certain percentage. This is known as “band” or “range” rebalancing.

To see how these strategies affect long-term returns, we tested our 60/40 portfolio over the nearly 80-year period since 1940 using different rebalancing strategies and none at all. (This was the longest set of reliable data we could find.)

We tested nine rebalancing portfolios and one with none, our “drift” portfolio. In terms of absolute returns, the drift portfolio performed best, with a 10% annual return. However in risk-adjusted terms, which we defined as annualised returns divided by annualised volatility, it performed the worst. Indeed, every portfolio which used a rebalancing policy, be it periodic or range based, outperformed the drift portfolio in risk-adjusted terms (see chart).

There is a “rebalancing premium”, at least in risk-adjusted terms

Doesn’t regular rebalancing incur costs?

It is true that regularly buying and selling assets is a more costly strategy than leaving a portfolio alone. As well as commissions paid to brokers, there is generally a spread between selling and buying prices that works against the frequent trader.

For the purposes of our illustration, we have ignored such costs, but we acknowledge that they can be substantial enough to outweigh the benefits of rebalancing. Choosing the optimum rebalancing strategy therefore involves a trade-off between the best risk-adjusted returns and the lowest level of costs consistent with achieving those returns.

Is rebalancing just an automatic process?

In short, no. Our research shows clearly that, while a rebalancing strategy should follow set rules, it also necessarily requires judgement. Not only do investors have to decide whether to rebalance or not, but also how frequently, the target allocation and the way the strategy should be implemented, among other things. Having the expertise to time rebalancing strategies based on economic environments is more difficult, but our experience suggests that having such a policy in place should help greatly during times of market stress.

We conclude that, even when markets are doing well, rebalancing produces superior risk-adjusted returns compared with doing nothing. As an integral part of the investment process, rebalancing should therefore bring rigour and discipline to the construction of the portfolio, while providing free long-run risk management. This is a combination that should commend itself to all investors, allowing them to sleep that bit easier at night and perhaps giving them the confidence to continue to build their savings.