The power of rebalancing your investment portfolio

When you read investment articles, a lot of time is often spent on the buying strategy. When to buy, how to buy and even what not to buy? However, less time is spent on the sell side of the equation.  As a result, many experts default to the buy and hold philosophy because it is easy and others because it has merits over the long run. All of this leads to a very important decision in the investment management process – managing and rebalancing a portfolio.

How should you manage a portfolio?

There are many theories and disciplines to managing a portfolio: Buy and hold, market timing, asset allocation, and even the every popular wing it strategy.  Personally, when it comes to managing my own portfolio, I subscribe to the rebalancing strategy.

The power of Rebalancing

Asset AllocationLet’s go back to 1990 and take a look at an example of a couple Garry and Vivian. Let’s assume they each have $100,000 to invest and for simplicity sake, they diversify into 4 different asset classes: Cash, Global Equities, Canadian Equities and Bonds. Let’s further assume that they take an unsophisticated approach to diversification and simply divide the portfolio by 4 and invest $25,000 into each of the 4 asset classes. Finally, let’s say Garry and Vivian buy the exact same investments.

After the first year, the four different asset classes all performed differently. Global Equities and Canadian Equities lost money and the other two asset classes made money. Here’s the exact numbers:

  • Cash gained 10.9%
  • Global Equities lost 16.4%
  • Canadian Equities was down 14.8%
  • And Bonds were up 7.3%

Garry decides to take the easy approach to managing the portfolio and implements the ‘do nothing strategy’. His financial advisor called it the buy and hold strategy. Year in and year out Garry figured that over time buy and hold was the way to go. After all, this was not an unusual strategy to follow. If it was good enough for Warren Buffet, then it was good enough for him.

Vivian, with the help of her financial advisor, took a little different strategy. Vivian decided to manage the portfolio by rebalancing the investment portfolio once a year. Simply put, this meant that she had to bring the portfolio back to its original balance where each asset class accounted for one quarter or 25% of a portfolio. For example, after the first year, she would sell a little bit of the bonds and cash to add to the global and Canadian equities.

And the winner is . . .

I went back to 1990 and used real performance data provided by Morningstar for the four asset classes. Each year, I compared Garry and Vivian’s portfolios with Garry’s portfolio being passively managed and Vivian’s is actively rebalanced every year. At the end of the first 10 years, who do you think had more money? At the end of 10 years, Garry’s $100,000 grew to a very respectable $277,710.

Vivian, with her active discipline of rebalancing fared better than her husband Garry. Her same $100,000 grew to $281,098.50. That’s almost $10,000 more. On a percentage basis, Vivian’s compound return was 9.1% compared to Garry’s 8.8%.

When you look at their progress at the end of 10, 20 and 25 years, you will see that Vivian comes out ahead by rebalancing the portfolio once per year.

buy hold 1990 2000 2010 2015
Cash $25,000.00 $44,387.16 $58,914.97 $58,939.78
Global Equity $25,000.00 $96,841.82 $91,740.86 $92,215.07
Canadian Equity $25,000.00 $68,097.60 $117,526.56 $117,992.94
Bonds $25,000.00 $64,310.77 $112,132.45 $112,427.52
$100,000.00 $273,637.35 $380,314.84 $381,575.30
rebalance
Cash $25,000.00 $68,178.18 $99,940.17 $100,244.76
Global Equity $25,000.00 $68,178.18 $99,940.17 $100,244.76
Canadian Equity $25,000.00 $68,178.18 $99,940.17 $100,244.76
Bonds $25,000.00 $68,178.18 $99,940.17 $100,244.76
$100,000.00 $272,712.72 $399,760.67 $400,979.02

 

Does rebalancing work?

I’ve read a lot of articles and many people feel that rebalancing can add 1% to 5% of value over the buy and hold strategy. In the example of Garry and Vivian, rebalancing added 0.2% compounded every year over 25 years. Differences in studies can come from different time frames and depends largely on what asset classes you use.

Rebalancing also helps to manage the risk.  You can see that after 25 years, the buy and hold strategy results in a riskier portfolio because 55% of the portfolio in equities and only 45% in fixed income.

According to these numbers, rebalancing adds value and manages risk. It is one of the best and simplest strategies to use to manage a portfolio. Rather than just buy and hold try to rebalance your portfolio. It will inevitably force you to systematically sell high and buy low.

Yearly investing and rebalancing

Garry and Vivian invested one bigger lump sum.  What happens if you invest some money every year.  Does the math of rebalancing change when invest every paycheque?  Every month? Or even every year?

Let’s look at another example of four brothers.

The four brothers

Let’s assume they each have $10,000 to invest each and every year from 1990 to 2015. For simplicity sake, they diversify into the same 4 asset classes: Cash, global equities, Canadian equities, and bonds. Let’s further assume that they also take an unsophisticated approach to diversification and simply divide the portfolio by 4. There is $2500 invested into each of the 4 asset classes. Finally, let’s say the four brothers buy the exact same investments.

After the first year, all four brothers have the exact same outcome and their portfolios are worth only $9,675 as the global and Canadian Markets had dismal performance. Now, for the second year, the boys all take a different strategy to managing the portfolios:

  • Sam, the do it again man, decides to stick with the original plan and invest the $10,000 into the same investments in the same proportion as the first year. This means, he puts in $2500 into each of the 4 asset classes every year no matter what happens the previous year.
  • Chase on the other hand decides that he is going to invest the $10,000 into the investment that did the best. As a result, Chase’s entire $10,000 went into cash the second year because of the poor market performance.  Every year, Chase decides he will continue to buy his best performing investment.
  • Ernie did the total opposite to Chase in everything in life and investing was going to be no exception. Ernie decided that rather than buying the best performing investment in the portfolio, he was going to buy the big loser of the year. Ernie puts his $10,000 into global equities with a -16.4% loss. Ernie continues to chase the loser year after year.
  • Finally, Jake decided to take a fourth and different strategy from the other brothers. Jake decides to rebalance the portfolio to the same mix as the original. For example after the first year, Jake still invests the $10,000 into all 4 different asset classes but the amount he invests into each asset class depends on how much is needed to bring it back to the original mix. Specifically, in the second year, Jake invests the $10,000 as follows:
    • Cash $2146.25
    • Global equity $2828.75
    • Canadian equity $2788.75
    • Bond $2236.25

Essentially, his rebalancing strategy is to buy more of the asset classes that performed poorly and buy less of the asset classes that performed well.

How did the brothers fare?

The differences between the brothers are much more staggering. At the beginning of 2000, After 11 years of investing $10,000 per year, Chase using the ‘chase the winners’ strategy, ended up with the least amount of money. Chase wound up with $194,774 equating a 9.44% compound annual return.

Next was Ernie with the chase the losers strategy. Ernie ended up with $202,560 and a 10.1% compound annual return.

Sam(the boring, easy approach) found himself as the big winner with $210,299 beating out both Chase and Ernie.

Jake wound up with $205,148 or an 10.31% compound annual return.

Here’s the data over 25 years:

1990 2000 2010 2015
Sam $2,500.00 $210,298.78 $414,488.27 $465,915.05
Chase $2,500.00 $194,774.17 $404,640.23 $456,102.58
Ernie $2,500.00 $202,560.87 $402,630.34 $453,847.54
Jake $2,500.00 $205,148.09 $425,375.94 $476,744.39

Right after 2000, Jake’s balance starts to pull ahead with his rebalancing strategy and after 25 years, rebalancing wins.

The last word

Whether you are investing one lump sum of money or whether you are investing more frequently over time, rebalancing is a strategy that ultimately adds value over time by enhancinh returns and managing risk. The great part of rebalancing is it is not hard to do from an investment perspective. However, experience has shown that is it very difficult to do from an emotional perspective. Rebalancing tries to get you to sell your winners and buy your loses which is something very difficult for most investors to practice. The bottom line is to stay disciplined and use rebalancing to overcome emotion. In the end, you will reap the rewards with this discipline.

Written by Jim Yih

Jim Yih is a Fee Only Advisor, Best Selling Author, and Financial Speaker on wealth, retirement and personal finance. Currently, Jim specializes in putting Financial Education programs into the workplace. For more information you can follow him on Twitter @JimYih or visit his other websites Group Benefits Online and Advisor Think Box.

2 Responses to The power of rebalancing your investment portfolio

  1. I really appreciate your comment on the emotional part of rebalancing. It can be hard to admit defeat when things are down and hard to sell those winners.

    What are your thoughts on how to manage fees during the rebalancing process? Is there are threshold to keep in mind when doing the rebalancing so that fees don’t eat into your capital too much?

  2. in ‘and the winner is” I can only see $3400. more in Vivian`s account not $10,000 as you states , am I missing something

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