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The best way to stay diversified

Asset allocation is a great way to structure your portfolio. Cris Sholto Heaton explains how to do it, and why rebalancing is important.

When you first set up a portfolio, you should decide how much you want to put in each asset. This is known as your target asset allocation. A simple example (not necessarily one we'd recommend) is to have 60% in stocks and 40% in bonds.

However, over time the make-up of your portfolio will drift away from this starting point, because certain assets will earn higher returns and so take up a bigger share of the portfolio.

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Usually it's the riskier assets that come to dominate (because they tend to make bigger returns), which means you lose the benefits of diversification.

For example, over several decades, the share of stocks in our example might drift up to around 90% of the total. To avoid this, every so often you have to reset your portfolio back to the target allocation. There are three main ways to stay diversified.

1. Time rebalancing. You rebalance yearly, quarterly, or even monthly.

2. Threshold rebalancing. You rebalance when the weight of an asset exceeds your target by a fixed amount perhaps five or ten percentage points.

3. Time-and-threshold rebalancing.You have a fixed rebalancing schedule, but choose not to rebalance if the excess in an asset is less than your threshold.

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There are trade-offs involved here. If you rebalance more frequently, you'll stick more closely to your actual asset allocation. But the more often you do it, the more costs you rack up in terms of trading expenses and taxes.

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So isthere an ideal rebalancing method? Research generally suggests the differences are modest. However, these studies tend to take the perspective of an institution or large portfolios, whereas the relative impact of costs on smaller portfolios is likely to be greater.

Allowing for that suggests that individual investors probably do better with strategies that rebalance less frequently.

A further complication is that studies typically focus on a simple portfolio of stocks and bonds and have been more interested in risk control (in other words, getting the most return you can for a given amount of volatility).

In reality, many investors will hold a wider range of assets and may well be more concerned about maximising returns than minimising volatility (the number of ups and downs you endure). So it's important to think about how rebalancing affects returns.

If markets are moving steadily upwards over time (trending), rebalancing will mean that your portfolio earns less than an "un-rebalanced" portfolio would have done. That's because you're selling the higher-return assets that have gone upby a greater amount and moving money into a lower-return asset.

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Our stock and bond portfolio is a good example: theun-rebalanced portfolio where the equity drifts up over time would have beaten the rebalanced one.

However, in markets that rise and fall around an average (in other words, ones that revert to a mean), the process of selling low and buying high works in your favour. In this situation, your rebalanced portfolio may beat the one that's left alone.

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And there is evidence to suggest that while markets trend over the short term, they mean revert over longer periods. So this suggests investors may do best choosing longer rebalancing intervals.

Taking into account both costs and returns, the best solution is likely to be time-and-threshold rebalancing. Once a year with a five-percentage-point threshold is a common rule of thumb. But the exact rule matters less than rebalancing in an organised way. And be sure to keep costs down by rebalancing at times when you plan to add money anyway.

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For example, dividends and bond interest can be ploughed back into whichever asset needs topped up. This is often enough to get its weight back within your threshold without paying extra costs.

When rebalancing is key to boosting returns

Most analysis of gains or losses from rebalancing focuses on whether markets are trending or mean reverting, but a paperby William Bernstein and David Wilkinson* showed why there can be a gain even where markets are not mean reverting.

The explanation is quite mathematical, but in essence they find that the overall gain or loss from rebalancing depends on two things: the difference in expected returns between the assets, and the volatility and correlation of the assets.

Where assets have very different expected returns, rebalancing tends to reduce returns the traditional stock/bond portfolio is a good example. However, where some assets are very volatile and have a low correlation to the rest of the portfolio, rebalancing them can boost returns.

That sounds complex, but Bernstein notes that precious metals stocks are a good example. Precious metals stocks have lower returns than the S&P 500 (9.21% versus 10.74% from 1963 to 2004), but much higher volatility and low correlation to other stocks.

However, the gains from rebalancing have at times been so great that the rate of return of the precious metals stocks within a diversified portfolio was almost five percentage points greater than the underlying return on the stocks, according to Bernstein. So if you invest in these kinds of assets, rebalancing is crucial to getting the best returns.

* William Bernstein and David Wilkinson Diversification, rebalancing and the geometric mean frontier (1997)

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