A well-designed portfolio is built to achieve an investor’s long-term financial goals within limits on portfolio volatility that are determined by the investor’s tolerance for risk.
Building such a portfolio can be accomplished by thoughtfully combining “asset classes” with different performance characteristics in a diversified portfolio.
An example would be stocks and bonds. Understanding the differences in the historic performance of stocks and bonds, makes it possible to combine them in ways designed to achieve specific long-term return targets within defined limits on portfolio volatility.
The resulting combination of asset classes is the portfolio’s “target allocation.”
Let’s say that, based on your personal goals and risk profile, we designed a portfolio for you with a target allocation of 60% stocks and 40% bonds.
For illustrative purposes only and does not represent the results of any investment.
As markets rise and fall, your portfolio’s asset class allocations could drift away from the target allocation. For example, in a rising stock market your portfolio might end up holding 70% stocks and only 30% bonds.
Rebalancing is the process of buying and/or selling portfolio holdings to return the portfolio to its target allocation. So, in this case, we would sell some of your stock holdings and purchase bonds in order to bring your portfolio back to its 60%/40% target allocation.
It may seem counterintuitive to sell assets that are performing well and purchase assets whose returns are lagging, but there’s a good reason for doing so. The reason is risk control.
As you can see below, historically, as the percentage of stocks in a portfolio increases, so does the potential for larger declines in portfolio value. Such declines can create anxiety, undermine confidence, and even cause an investor to abandon their investment strategy.
So, we try, through rebalancing, to lower portfolio volatility. This helps you weather market turbulence as comfortably as possible, while you make progress toward your financial goals.
Notes: Data are from Dimson-Marsh-Staunton (DMS) dataset for 1901-2022. Annualized nominal geometric returns are in dark green. The 5th and 95th percentiles are plotted below and above asset mixes. Bar length indicates the range, from 5th to 95th percentile, of annual returns for each allocation; the longer the bar, the larger the variability. The numbers next to each bar represent the average nominal annual returns for that allocation for the 122 years covered.
Source: Vanguard’s Principles for Investing Success. 15 Nov. 2023. Data Sources: Vanguard calculations, using DMS global returns data from Morningstar, Inc. (the DMS World Equity Index and the DMS World Bond Index, both in nominal and real terms). The dataset includes returns from Australia, Austria, Belgium, Canada, China, Denmark, Finland, France, Germany, Ireland, Italy, Japan, then Netherlands, New Zealand, Norway, Portugal, Russia, South Africa, Spain, Sweden, Switzerland, the United Kingdom, and the United States. Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
The table below shows the year-to-year performance of a variety of asset classes, including US and global stocks and US and global bonds. It also shows the performance of an “Asset Allocated” portfolio of 60% stocks/40% bonds that combines all four of these asset classes together (the dark blue boxes).
You can see that performance of the individual asset classes varies quite a bit from year to year. Asset classes that perform well one year may perform poorly in subsequent years.
The 60%/40% portfolio is not the best performing alternative in any single year. As you might expect it consistently performs in the middle of the pack. And its performance relative to the individual asset classes is very consistent over time.
Rebalancing helps achieve this outcome. By maintaining the portfolio’s target allocation, the stocks give it a lift during rising markets and the bonds cushion it during market declines.
There are many approaches to rebalancing. Some strategies call for periodic rebalancing—monthly, quarterly, annually. Others are triggered when actual asset allocations depart from target allocations by a certain percentage. Some combine these two approaches.
The research shows that there is no perfect rebalancing strategy. The benefits of each vary depending on the performance of the financial markets—something we can’t know in advance.
A study done by Vanguard in 2019 (see "Disclosures" for details) examined how a wide range of rebalancing strategies would have performed from 1926 through 2018. Interestingly, the returns and volatilities of the portfolios utilizing different strategies were remarkably similar. The study found no material performance advantages to choosing one rebalancing strategy over another.
But the Vanguard study did find very significant advantages to employing some form of rebalancing strategy compared to no rebalancing at all.
First, it found that rebalancing strategies were all good at maintaining the integrity of a portfolio’s target allocation. A 60% stock/40% bond portfolio that was rebalanced regularly had an average stock allocation over time of between 60% and 63%. Portfolios with similar target allocations that were not rebalanced had an average exposure to stocks of 85%--far too high.
The study also found that the volatilities of all rebalanced portfolios were significantly lower than the volatilities of portfolios that weren’t rebalanced. For example, the graph below shows that, on average, the annualized volatilities of 60%/40% portfolios that were rebalanced quarterly were significantly lower than those of portfolios that weren’t rebalanced.
The study further found that rebalanced portfolios had greater return per unit of risk taken than portfolios that weren’t rebalanced. (This is known as a portfolio’s “Sharpe ratio.”)
You can see in the graph below that portfolios that were rebalanced quarterly had higher Sharpe ratios (higher is better), on average, than portfolios that were not rebalanced at all.
Source: Vanguard study: “Getting back on track: A guide to smart rebalancing. See “Disclosures” for more information.
The Vanguard study led to two important conclusions about rebalancing. First, rebalancing can provide benefits over not rebalancing. Second, it doesn’t make much difference which rebalancing strategy you use, as long as you apply it consistently over time.
Any rebalancing strategy you use should take transaction costs and taxes into consideration. Frequent rebalancing can generate transaction costs and taxes that undermine the benefits of rebalancing.
Having a predetermined, easy-to-follow rebalancing rule in place is important.
The graphics taken from the Vanguard study: “Getting back on track: A guide to smart rebalancing,” were generated by the Vanguard Capital Markets Model (“VCMM”). The VCMM analyzes the likelihood of various investment outcomes.
Outputs from the VCMM are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.
Distribution of return outcomes were derived from 30-year forecasts of global equity, fixed income, and risk- free rates using 10,000 simulations for each modeled asset class. Simulations are as of December 31, 2018. Results from the VCMM may vary with each use and over time.
Please note the information contained in these reports is not written or intended as financial, tax or legal advice. This article is for dissemination of general information only. Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. Investments are not guaranteed and are subject to investment risk, including possible loss of the principal amount invested. Past performance is no guarantee of future results.