I recently came across an article from William Bernstein explaining how periodic rebalancing is likely to affect the return in your portfolio.
The language in the article is a bit technical, but the message is important. The following is my attempt to put it in everyday terms (with some of my own explanations/interpretations mixed in).
What we’d expect: weighted-average returns
Imagine a portfolio made up of a 75/25 allocation between a stock index fund and a bond index fund.
If, over the next 10 years, the stock market were to earn an 8% return, and the bond market were to earn a 4% return, we might expect the portfolio (with its 75/25 allocation) to earn a return equal to the weighted average of the two–a 7% return.
Weighted Average Return = .75 (8%) + .25 (4%) = 7%
If the portfolio is rebalanced regularly throughout the 10-year period, however, the results are different. In fact, in most cases, the portfolio ends up earning a return that’s slightly greater than the weighted-average return of its components. (Bernstein refers to this additional return as the “rebalancing bonus.”)
Why does this happen?
In short, it’s because regular rebalancing is a way to force yourself to buy low and sell high.
The idea is that decreasing your exposure to the portion of your portfolio that’s just performed best, while increasing your exposure to the portion of your portfolio that’s underperformed should improve your performance. It doesn’t always work, but apparently it works more often than not.
How much additional return can we get?
Well, that depends on a couple variables. Specifically, it depends upon:
- The volatility of each of the asset classes, and
- The correlation between the two asset classes.
In order to maximize the rebalancing bonus, we want the volatility of each asset class to be high, and we want the correlation between the two to be low.
How we can profit from this information
It’s common sense that we can reduce portfolio volatility by adding an asset class that has little correlation to the rest of the portfolio. What’s fascinating to learn is that if the asset has an expected return equal to the rest of the portfolio, including it in the portfolio would not only decrease volatility but probably increase return as well.
Alternatively, if the asset has an expected return that’s less than the rest of the portfolio (as would be the case with adding a bond component to a stock portfolio), including it in the portfolio is unlikely to decrease expected return as much as we’d intuitively expect.
In other words, some of the return we sacrifice by including an asset class with a lower expected return than the rest of the portfolio is made up for in the form of a rebalancing bonus.
Takeaway #1: When constructing a portfolio, the correlation of the asset classes involved will affect not just your portfolio volatility, but your overall return as well.
Takeaway #2: Any asset that’s both highly volatile and uncorrelated to the stock market (gold, for instance) can make a lot of sense as a small portion of a portfolio due to the fact that it’s likely to contribute a greater return for the portfolio than would be indicated by the asset’s stand-alone return.