Tweak your way to riches by rebalancing your portfolio

published 23 September 2016

Timing the market is a mug's game. The evidence shows clearly that jumping in and out of stocks, hoping to catch the highs and the lows, is bad for your wealth. For example, in 2011 the University of California's Brad Barber and Terrance Odean looked at the track records of Taiwanese day traders. They found that between 1992 and 2006 only 1% were consistently profitable. In another study they found that even successful day traders paid so much in brokers' fees that it outweighed any outperformance they achieved.

So should you move to the other extreme and "buy and hold" forever? It's certainly more sensible than day trading. But "buy and forget" can leave you heavily exposed to certain assets during boom times and have you biting your nails during a crash. This is where "rebalancing" comes in.

This is the idea that you can reduce risk, without hurting your returns, by deciding what proportion of your portfolio you want to hold in which assets, then sticking to this allocation over time by regularly selling the best-performing assets and topping up the worst performers. This should prevent you from being overly exposed to any one asset, and also forces you to sell out of assets that have grown expensive, and reinvest in those that are cheap.

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Both common sense and the data suggest that rebalancing works. Morgan Stanley notes that between 1977 and 2014 a portfolio split equally between US bonds and shares would have performed better if rebalanced annually than if a simple "buy and hold" approach was taken. The rebalanced portfolio turned $1,000 into $2,017; the "buy and hold" portfolio, $1,786.

A similar study by Forbes found that for a 60/40 split between stocks and bonds, rebalancing would have boosted returns by 9% between 1985 and 2010. Better yet, in each case, rebalancing reduced volatility in other words, the investor would have endured fewer dramatic ups and downs.

Rebalancing does rely on two assumptions. Firstly, that assets mean-revert. In other words, expensive assets eventually become cheap, and vice versa. Secondly, that this will happen in a timescale compatible with your investment horizon. After all, market trends can last for a long time: rebalancing would have significantly reduced returns in the 1990s boom, for example, because it would have resulted in a lower allocation to stocks.

However, the flipside is that rebalancing would have reduced volatility and anyone who has watched their portfolio shed half of its value in a major crash will understand the value of that. As for how often to rebalance, we'd suggest that once or twice a year is sufficient. Anything more than that runs the risk that your trading fees will end up offsetting the benefits.