Portfolio Rebalancing Returns
Posted August 5, 2011on:
In one of my previous posts, I showed how diversification across asset classes is superior to momentum and contrarian strategies. Today, I am going to show how disciplined rebalancing adds to returns. I will first demonstrate this using a stylized example and then through historical returns.
An example of two asset classes
Assume that there are only two asset classes in the world. Asset class A is a risky asset class; its value goes from 10 to 5, then back to 10 in three periods. Asset class B is a riskless asset class; its value stays at 10 throughout the three periods.
Rebalancing vs. non-rebalancing
Investor S invests in a 50/50 portfolio consisting of $10 of asset class A and $10 of asset class B in period 1. In period 2, when the value of asset class A plummets to $5, he rebalances by selling $2.5 worth of B and buying $2.5 worth of A, thus maintaining the 50/50 allocation target of $7.5 each. In period 3, asset class A rallies 100% and the value in the portfolio goes up to $15, while asset class B stays at $7.5. The total portfolio value is $22.5 in period 3.
Investor D also invests in the same 50/50 portfolio, but he does not rebalance his portfolio. In period 3, the value of his portfolio is $20. See table below for a comparison.
|Portfolio with rebalance (S)||Portfolio w/o rebalance (D)|
The additional $2.5 investor S earns is the rebalancing return. It is the return resulting from selling high (asset class) and buying low (asset class).
You may say: Michael, I see your point, but does it really work in the real world? Yes, it does.
Let’s look at the Black Rock asset class return chart. There are nine asset classes in the chart. Let’s examine a portfolio that invests $10,000 in each of the nine asset classes. The table below shows the 20 year returns from 1991 to 2010.
|Portfolio with rebalance||Portfolio w/o rebalance|
|1991 starting value||$90,000||$90,000|
|2010 ending value (return)||$467,848 (420%)||$447,541 (397%)|
|Portfolio volatility or risk||13.29%||15.0%|
As you can see, the portfolio with rebalancing is ahead of that without. And, it achieves better performance with less volatility!
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