Take This Test: How Well Do You Understand Rebalancing?
It's time to critically examine the conventional wisdom around portfolio rebalancing
Over 17 years at Advisor Perspectives, we have reshaped advisory thinking – whether by championing innovative strategies like Allan Roth’s TIPS ladders or by highlighting the groundbreaking retirement planning insights of Wade Pfau. These contributions set the stage for reexamining other long-held investment dogmas.
But no contribution was as significant, yet as widely misunderstood, as a series of articles (here, here and here) by Michael Edesess that dispelled the conventional wisdom about the value of rebalancing in retirement planning. Edesess’ work was affirmed a week ago by Victor Haghani and James White of Elm Management in an article they published, which prompted me to revisit the topic.
The conventional wisdom is that rebalancing is a way that advisors can add value, either by increasing return or reducing risk, and should be done on a periodic basis. But is that true?
I invite you to take the following test. Which of the following statements about rebalancing are universally true:
“Rebalancing is an important way to help minimize volatility in a portfolio and may improve long-term returns.” (T. Rowe Price)
“Rebalancing too frequently can sacrifice returns while rebalancing infrequently can increase portfolio risk.” (Investopedia)
“Rebalancing quarterly increases the portfolio’s Sharpe ratio, meaning that the rebalanced portfolio produces more return per unit of risk than the non-rebalanced portfolio.” (Vanguard)
“No rebalancing at all results in far higher levels of portfolio volatility. All of the other rebalancing frequencies led to similar reductions in portfolio volatility and improved risk-adjusted returns (as measured by the Sharpe ratio) over the trailing 15-year period. “ (Morningstar)
“Systematic rebalancing raises the likelihood of improving long-term risk-adjusted investment returns.” (Research Affiliates)
“Portfolio rebalancing, when done effectively, can help manage risk and keep your clients on track to pursue the expected returns desired to meet their goals.” (Betterment)
“We think about rebalancing as primarily an exercise in risk control – that is, one that keeps a client’s portfolio characteristics in line with the target asset allocation that has carefully been developed.” (Brown Brothers)
“We do not find evidence that rebalancing choices can reliably increase expected returns.” (Dimensional Fund Advisors)
“The benefits of rebalancing a portfolio include helping to manage risk, as assets that have grown significantly may alter the intended balance of risk and reward.” (Nasdaq)
“Portfolio rebalancing is an important aspect of investment management to increase tax efficiency while minimizing risk by maintaining the desired asset allocation in a portfolio.” (SEI)
Before I reveal the answers to this test, let’s review the key findings from the research by Edesess, Haghani and White:
There is no “rebalancing bonus.” Both simulated (Monte Carlo) analyses and empirical data reveal that, before accounting for transaction costs, the return differential between a rebalanced portfolio and a buy-and-hold strategy is negligible. That is true regardless of the rebalancing frequency. As the rebalancing frequency increases, so do the transaction costs, and the benefits of buy-and-hold versus rebalancing will increase.
As the difference between the returns of stocks and bonds increases, so would the return for a buy-and-hold portfolio, as would its volatility (standard deviation).
Rebalancing produces a higher return than buy-and-hold in about two thirds of the scenarios. But when buy-and-hold outperforms, it does so by a larger margin. The net result across all scenarios favors neither rebalancing nor buy-and-hold.
While rebalancing can realign a portfolio’s risk profile, its ability to reduce risk hinges on how risk is defined. For long-term, retirement-oriented investors, conventional measures like standard deviation may not capture the full picture – leaving the purported risk reduction debatable. As noted in the previous point, buy-and-hold increases volatility as measured by the standard deviation of returns. But for a retirement-oriented investor with a long (20- or 30-year) horizon, volatility is not necessarily the right definition of risk. Edesess looked at an alternative definition – the standard deviation of ending wealth – that makes more sense given the profile of the typical retirement-oriented investor. But even that definition has problems (most of the supposed risk is in the volatility of upside returns). On balance, there is no clear evidence that rebalancing reduces risk.
There is a negligible difference in risk-adjusted return between rebalancing and buy-and-hold, regardless of rebalancing frequency.
Rebalancing is a worthy exercise to align a portfolio with an investor’s risk tolerance and pursuit of financial goals. If a portfolio has drifted to have a large enough allocation to risky securities to make the client uncomfortable, it should be adjusted. Likewise, once a client’s portfolio has accumulated enough assets to sustain their desired standard of living, risk in the allocation should be reduced. Those are asset allocation decisions where an advisor can add value.
But prescribing a periodic rebalancing frequency to increase return or reduce risk is unnecessary, unsupported by the data, and is likely to detract from wealth through increased transaction costs.
The evidence supports the validity of statements 7, 8, and 9. I invite you to share your insights and test results in the comments section below.
Robert Huebscher was the founder of Advisor Perspectives and its CEO until the company was acquired by VettaFi in 2022. He was a vice chairman of VettaFi/TMX until April 2024.