Rebalancing Gets More Attractive as Stocks-Bonds Correlation Lowers

Stock and bond price co-movements appeared to decouple a few years ago, which exacerbated an already decades-old trend. Although the two asset classes don’t move in perfect lockstep–one falls while the other rises, and vice versa–it seems that correlations are much lower than they have been.

If one uses historical assumptions on correlation levels, efficient frontiers will restrict the amount of the riskier asset. The result is likely a lower realized return, which partly explains the shortfall of many defined benefit plans. One way to combat this problem is portfolio rebalancing, which involves taking money out of investments that have done well and putting it in investments that haven’t. This practice ensures that an investor’s asset allocation mix does not vary too much from its initial targeted amounts, which prevents concentration in a particular investment.

When one asset is on a tear, as during periods when stocks are dramatically outperforming bonds, for example, rebalancing will not increase the return of a portfolio. But during stagnant markets or periods when the correlation between assets is low (sound familiar?), rebalancing can add a ton of value.