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Portfolio Rebalancing: Shelter in the Storm

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The performance of equities and fixed income securities during the third quarter emphasizes a valuable lesson for all investors-the benefits of owning a little bit of everything far outweigh the gamble that one asset class will outperform all others in every market condition.

Take U.S. stocks, for example. After several years of returns well above historical norms, a generation of investors came to the mistaken conclusion that an all-equity portfolio all but guarantees riches. There’s no denying that stocks fared well in the last one hundred years, but consider that nearly one-half of the gains from 1934 to the market top in March 2000 have been erased in the current bear market of the last 29 months. The result? Instead of owning Wal-Mart stock, many of these buy-and-hold aficionados, now at retirement age, are finding themselves employed by the company as greeters.

The waxing and waning nature of the capital markets has prompted investment professionals to devise methods for reducing the risk of traditional portfolios. The so-called constant mix rebalancing method seeks to maintain a consistent asset allocation recipe; the main intent is to prevent overconcentration in a particular market sector or asset.

Another motive behind rebalancing is to capture the extra return that can be gleaned from reallocating from outperforming asset classes to underperforming ones. This so-called rebalancing bonus exists because investments such as stocks and bonds tend to move independently of one another. For example, when stocks swoon, bonds rise in value; rebalancing prevents portfolios from becoming overweighted in a given outperforming asset class.

The chart below shows the rebalancing bonus, in percent per year, for each of the last five decades. Although these extra returns are impressive, the bonus gleaned from rebalancing in the last few years has been astonishing. For example, a 60% stock/40% bond portfolio rebalanced quarterly gained 4% more in 2000 than its non-rebalanced counterpart; in 2001, the differential was nearly 5%!

Constant-mix rebalancing does not always increase the absolute return of portfolios. As Bill Sharpe has pointed out (“Dynamic Strategies for Asset Allocation,” Financial Analysts Journal, January/February 1988: p. 16-27), the strategy adds value during stagnant market conditions, while buy-and-hold investors do better during uptrends. However, the benefits of the latter approach come at the cost of gradually increasing portfolio risk.

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