Periodic Portfolio Rebalancing
The generally accepted wisdom is that portfolios should be periodically rebalanced to bring each asset class back to its original target percentages. There are three reasons why this is considered important:-
Overcoming Human Instinct to Sell High and Buy Low: private investors are often accused of buying during market bubbles and selling during the crashes – buying high and selling low. Periodic rebalancing forces the investor to behave against his instincts and sell assets when they are rising and buy assets when they are falling.
Truth or Myth – Rebalancing Reduces Portfolio Growth?:
Portfolio Visualizer allows you to simulate portfolios with or without periodic balancing. The table below compares the growth rates with and without annual rebalancing from nine different (USA-based) portfolios. You can see the exact portfolio constituents on the Portfolio Visualizer website.
The results certainly don´t support the “momentum” case against periodic balancing with 8 out of the 9 portfolios producing slightly higher growth when annually rebalanced.
Balancing or Not For The UK? There is a little more evidence that for UK biased portfolios that there is a slight improvement in performance with no rebalancing. Analysing 81 thirty-year investment periods starting in each year from 1910 to 1990 with an initial 60% UK equities (basically FTSE All share) and 40% gilts (duration 15+ years).
54 (81%) of the periods showed improved performance when there was NO rebalancing. Not a great improvement, the average was 0.37%, but over a 30 year investment period, this represents a healthy increase in the portfolio value. The 27 periods that benefited from annual rebalancing showed an average of a 0.4% gain in annualised growth.
Not Rebalancing Creates Risk or Does It? Of course, the consequence of not balancing is that the equity portion of the portfolio will start to dominate and this will produce more risk and more volatility. Of the 81 portfolios, fifty had an equity content of more than 70% at the end of 30 years and thirteen had more than 90%.
In the next section, I´ll look at alternatives to periodic rebalancing, sometimes called Income Harvesting, some of which have been shown to improve the Safe Withdrawal Rate (SWR) of a portfolio in drawdown despite many of these strategies increasing the equity portion of the portfolio during drawdown which is counter-intuitive to the normal advice of reducing bond holdings with age.
Alternatives to Periodic Rebalancing – Income-Harvesting
- Sell the best performing asset to generate drawdown cash
Is Portfolio Rebalancing Necessary in Drawdown?
- Withdraw money from either stocks or bonds and then rebalance the portfolio annually to the initial stock/bond proportion. This harvesting rule will be referred to as “Rebalance.”
- Withdraw money from the asset that had the highest return during the year and do not rebalance. This will be referred to as “High First.”
- Withdraw money from the asset that had the lowest return during the year and do not rebalance. This will be referred to as “Low First.”
- Take withdrawals from bonds first and do not rebalance (“Bonds First”).
- Take withdrawals from stocks first and do not rebalance (“Stocks First)”.
“ bonds first, over stocks, the best of all the methods, though the resulting stock-heavy portfolio may make some investors uneasy. This method also is most apt to leave a larger remaining balance at the end of 30 years, while rebalancing leaves the smallest amount.
The table below shows the performance of different income-harvesting strategies for the UK market with an SWR based upon 100% success.:-
Here is how Prime Harvesting works: