When Uncle8888 saw this article popping up as FB notification; his eye opened wide! He doesn’t want to get this to mistake too! Beware the traditional wisdom. Retirees (and soon-to-be retirees) should regularly rebalance their portfolios, right? That advice seems unobjectionable, of course. It certainly is repeated often enough. But Humphrey Neill, the paternal father of contrarian analysis, advised us to be skeptical of any advice that is almost universally repeated.
This will help to reduce the likelihood of bad draw-down on volatile assets during market low and help reduce the chance of asset price recovery. The occasion to take a second to take a look at rebalancing was my recent Retirement Weekly column, in which I reported on the long-term performance of several hypothetical pension portfolios that involve regular rebalancing.
Many of those portfolios performed considerably worse than expected, and rebalancing was the likely culprit. My re-examination led me to a fresh research that exhaustively examined rebalancing. It discovered that rebalancing increases performance only if the markets behaving in certain specific ways. Plus they don’t always achieve this. The traditional promise of balancing, of course, is that it boosts returns. By selling marginal portions of assets which have outperformed constantly, and buying more of positions that have underperformed, you in place are buying low and offering high. Along the way you are cutting your risk.
Notice carefully, however, the implicit assumption behind these guarantees: An asset that has underperformed in a single period is likely to perform better within the next, and vice versa – reversion to the mean, quite simply. That is not always the situation. Consider the 2007-2009 financial meltdown. The stock market fell for six calendar quarters in a row, with its loss getting bigger as the problems unfolded steadily.
- 8 years ago from Somewhere in the middle of it all
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A strategy of regular rebalancing would have magnified losses rather than reduced them. Notice further that even though you’re right about reversion to the mean you can still lose cash when rebalancing. You also have to get the right rebalancing frequency. If you rebalance quarterly, for example, you implicitly are let’s assume that one-quarter’s outperformer will be the subsequent quarter’s underperformer.
If you balance at a yearly frequency, on the other hand, you’re assuming that reversion occurs at that longer frequency. Unfortunately, there is absolutely no persistence to when reversals occur. They occur at regular regularity Sometimes, but other times not. The same holds true for quarterly and yearly time horizons. To illustrate the inconstancy of reversal frequency, I consider a statistic known as the correlation coefficient.
No question rebalancing doesn’t always improve performance. Now, the analysts found that generally an incorrect rebalancing assumption leads to only a humble drag on portfolio performance. Where regular and frequent rebalancing really costs you can be an extended keep market, like the 2007-2009 financial crisis. Fortunately, the analysts identify a remedy: Combine rebalancing with a momentum strategy. Such a combination works because the assumptions behind a momentum strategy are the opposite of those underlying rebalancing: Momentum works to the degree that trends persist, as opposed to the development reversals assumed by rebalancing.