It is said rebalancing controls for risk. If your chosen allocation to equities is 60 per cent and a bull market pulls it up to 80 per cent, you’ll be going into the next bear market with too much risk. Vice versa, if a bear market pulls it down to 40 per cent you’ll be going into the recovery with too little risk.

Rebalancing is also said to compel buying low and selling high. Your equity allocation usually falls below the chosen allocation during bear markets, compelling you to buy stocks in the midst of pessimism. It usually rises above the chosen level during bull markets, compelling you to sell stock in the midst of optimism.

Many people think rebalancing is done just once a year. There are actually many other possibilities and studies have shown they can generate better returns. Let’s review main alternatives (what follows is a slightly modified version of an article I wrote a while back).

1. In their study published in the November, 2006 issue of the Journal of Financial Planning, David Smith and William Desormeau tried out different rebalancing rules on various U.S. bond-stock model portfolios over the 1926 to 2003 period. They found that rebalancing every three to four years outperformed monthly, quarterly and annual rebalancing.

2. John Bogle does not rebalance his portfolio. A few years ago, the Bogle Financial Markets Research Center found that annual rebalancing of a stock-bond portfolio in all the 25-year periods from 1826 onwards only outperformed an unadjusted portfolio 52 per cent of the time. This would seem to suggest it doesn’t matter either way if one rebalances or not. However, Bogle discovered that when a portfolio was never rebalanced, the annual underperformance was never more than 0.5 percentage points but when it outperformed, the extra gains were often 2 to 3 percentage points annually.

3. Why might rebalancing less frequently than every year yield better performance (every 3 to 4 years versus annually or less, as found in the David Smith and William Desormeau study)? The likely explanation, at least in part, could be the tendency for financial markets to trend in the short term before mean reversion sets in. In other words, if market prices are characterized by momentum, it does not pay to shift often out of winning into losing investments. That increases the weight of the declining positions and lowers the weight of the appreciating positions, resulting in lower returns overall.

4. The “threshold” approach doesn’t rebalance according to the calendar. It calls for adjusting weights only when assets diverge from the target allocation by some specified amount. A common variant is the 5/25 method, as described by Larry Swedroe in his book, The Only Guide to a Winning Investment Strategy You’ll Ever Need. It calls for rebalancing if “the change in an asset class’s allocation is greater than either an absolute five percent or 25 percent of the original percentage allocation,” whichever is less. For example, the threshold bands for a position with a 10-per-cent allocation would be 5 to 15 per cent or 7.5 to 12.5 per cent – with a preference for the latter since it is smaller.

5. Then there is “tactical” rebalancing. Beside uncovering evidence that infrequent calendar rebalancing performed better, the Smith and Desormeau study mentioned above found that Federal Reserve monetary policy had a discernible impact on rebalancing returns. In fact, they found that the “best rebalancing policy is dependent on, and can be planned around, the Fed’s prevailing monetary policy.” In short, rebalancing every three to four years was better than rebalancing annually, and furthermore, synchronizing the three- to four-year frequency to the monetary cycle was better than doing it without reference to the monetary cycle.

6. Another rebalancing strategy with the potential to deliver extra returns is offered by Warren MacKenzie, president of Weigh House Investor Services. It’s based on a price-to-earnings (P/E) valuation rule and goes as follows: say the preferred allocation to equities is 50 per cent and the P/E ratio for the stock market is higher than 25. Then shift to a lower allocation such as 40 per cent. If he market P/E is below 12, then shift to 60-per-cent equity.”

7. Gobind Daryanani advocates “opportunistic rebalancing” in the January, 2008 edition of the Journal of Financial Planning. It involves closely monitoring asset allocations to see if they move outside threshold bands. He found the width of the bands and frequency of checking had an impact on returns. Specifically, monitoring a threshold band of 20 per cent around the chosen allocation on a bi-weekly basis constituted the optimal strategy in terms of capturing opportunities to buy low and sell high (i.e. increasing returns to rebalancing). The margin was reduced somewhat after factoring in all costs, taxes, and risk, but still positive.

8. Rebalancing has its “fat tail” too – a situation where portfolio ruin occurs. A current illustration is the 25-year downward trend in Japanese equities. Rebalancing on a long-term declining trend can wreck havoc with a portfolio. As lengthy downtrends tend to happen after periods of mania and euphoria, investors should perhaps be wary of starting a rebalancing program in such environments (indeed to having any significant exposure).

9. Some rebalance by selling off part of the winners and buying more units in the losers, while others rebalance by funneling cash injections (and dividends, interest income) into the losers. Practitioners of the latter approach are keeping costs down by avoiding the commissions arising from selling the winning position. But they are letting, some say, the winning position go further into possibly overvalued territory, which increases the risk of experiencing a sharp correction (buying low but not selling high).

10. Shorter investment periods and lower volatility reduce the need to rebalance, say Stanley Pliska and Kiyoshi Suzuki in their study published April, 2004 in Quantitative Finance. They also point out that if there is a high degree of correlation between holdings in a portfolio, no or little rebalancing may be necessary (if asset prices largely move in unison, the relative weights of the assets don’t drift much)

Wrap-up: Many studies have examined different ways to rebalance and found that returns can be maximized in certain ways. While instructive, these results may be dependent upon the historical series used. Moreover, the less visible aspect of risk should not be overlooked. Some approaches may raise returns but the trade-off can be higher risk levels. Indeed, for many investors, rebalancing is not about boosting returns but controlling risk – i.e. maintaining their portfolio allocations reasonably close to their risk tolerances. They are willing to accept the possibility of lower average returns for the sake of minimizing exposure to setbacks exceeding their risk tolerances. But then again, others may prefer going for higher returns.

Postscript: Just to further illustrate the diversity of rebalancing methods, the rule in the One-Minute Portfolio is to raise equity exposure when a moving average of the market index is below the average annual historical return on equities and lower exposure to equities when it is above.

Serious Money
Richard A. Ferri

“Real estate is one of the few asset classes that have had a low correlation with stock and bonds.”

“Commodity total return indexes have a low correlation with other asset classes, but they also have historically low returns.”

“For most individual investors the (hedge fund) disadvantages of high cost, low disclosure, lack of diversification, illiquidity of some funds, and poor consistancy of performance far outweigh the benefits.”

“A large majority of investment advisors have an ulterior motive, namely, selling investment products that pay them commission and fees.”

“The ‘free lunch’ from rebalancing is the essence of Modern Portfolio Theory.”

“During a time of extreme volatility, when you want low correlation between asset classes, positive correlation can increase dramatically.”

Smart and Simple Financial Strategies for Busy People
Jane Bryant Quinn

“It’s an error to put college ahead of retirement savings, if you can’t afford both. Kids can always get student loans — but banks don’t make retirement loans.”

“With just a few index funds, you can create your own well-diversified portfolio.”

“Never concentrate your investments in a single company, especially the company you work for.”

The Smartest Investment Book You’ll Ever Read
Daniel Solin

The vast majority of investors do not need any advisor or broker.”

“It is of great significance (and a deep, dark secret rarely discussed by hyperactive brokers and advisors), that in excess of 90 percent of actively managed mutual funds fail to equal or beat the benchmark indexes over the long term.”

“Once you accept the premise that asset allocation is far more important than stock picking or market timing, your financial life becomes a stress-free walk in the park.”

“When you have two asset classes in your portfolio that do not correlate highly with each other, you minimize yur risk significantly.”

Straight Talk on Investing
Jack Brennan

Living below your means is the ultimate financial strategy.”

“A broad stock market index fund, a broad bond market index fund, and a money market fund will give you everything you need.”

“Investing with simplicity is liberating because it lets you live your life.”

The point of rebalancing is to manage your risk, not to maximize your long-term returns.”

“For most people, an annual rebalancing is adequate.”

To be continued … here.

The One-Minute Portfolio (OMP) is a member of the lazy-portfolio species, consisting of just two exchange traded funds: iShares S&P/TSX 60 Index ETF (XIU) and the iShares Canadian Bond Index ETF (XBB). It was created in early 2003 and has been rebalanced annually since, as described in articles on the MoneySaver and Canadian Business websites. The average annual gain since inception is now about 8%.

As a member of the lazy portfolio species, the unique feature is how the allocation between equities (XIU) and bonds (XBB) is determined. It doesn’t rebalance back to a fixed asset allocation as most lazy portfolios do but takes into account whether the stock market is under or above its long-term average annual return. For more details on the method, check out the December 18, 2008 Canadian Business article.

During the last rebalancing (in December of 2008) the allocation to equities (XIU) was raised from 40% to 60% because stock markets were then noticeably below their long-term average return. By default, the allocation for bonds (XBB) went from 60% to 40%.

I would think longer term. There will invariably be a reversal at some point. But we have just been through a substantial recession and the central banks are now goosing the money supply big time. Historically, this kind of scenario spawns an extended multi-year appreciation in stocks, characterized by higher highs and higher lows. Your best bet will likely be to sit tight and ride the longer swing.

Excessive trading of peaks/valleys or rebalancing of holdings raises costs that eat into returns over the long run. There is also the issue of market timing. It’s very hard to sell near the peak and buy back in at the bottom of short-term fluctuations – the end result will likely be a lower return than simply holding.

Rebalancing, of course, has its place. Many investors do it annually and this would make sense for those concerned about maintaining a risk level they are comfortable with. However, those with high risk tolerance might not worry about annual rebalancing for two or three years in the current environment.

They could in time become concerned about the bull market ending. In that case, they may consider techniques such as “risk budgeting,” as Mark Yamada of PŮR Investing Inc. epsouses. Or simply begin a regular annual rebalancing.

Index-fund pioneer John Bogle has said he doesn’t think rebalancing is necessary at all. If one is a true believer in the thesis that stocks return 7% to 9% annually over 15- to 30-year periods, then all that volatility along the way does not need to be hedged away with rebalancing.

Risk budgeting is employed by “sophisticated pension plans seeking to maximize their potential returns.” Instead of using a fixed asset mix, they use “constant risk rebalancing” to manage asset allocations.

“Traditional money management often ignores the fact that markets are sometimes more risky than at other times,” notes Yamada. During the tech bubble, those investors guided by a fixed asset mix were trimming equity weights back to a preset allocation such as 60% stocks and 40% bonds. But those guided by risk budgeting would be cutting back on stocks even more and taking stock allocations below 60%.

PŮR’s risk budgeting approach uses volatility as an indicator to make “subtle shifts in the portfolio.” Volatility may be defined as the 252-day moving average of standard deviations of daily changes in the S&P 500 Index. The CBOE Volatility Index (VIX) may also be OK to use “in a pinch,” but has greater variation.

“Before the “tech wreck” the technology sector was 8% of the S&P 500 Index and at the peak it was over 30%! At the same time, the 252-day moving average of the S&P 500 volatility moved from about 12.5 to over 15,” says Yamada.

“When volatility, as defined above, is falling or stable, a more positive market is suggested. More importantly, when volatility is rising, assuming less portfolio risk is indicated.”

Adds Yamada: “We think timing the market is generally a ‘mugs’ game. It’s expensive and hard to do consistently. However, as a form of insuring a portfolio against big negative downdrafts, volatility is an interesting indicator.”

His firm is also investigating use of the ‘VIX ETFs’ (VXZ and VXX) in this context too.

The One-Minute Portfolio (OMP) is a passively indexed portfolio, one that runs with a minimum of effort. It has been rebalanced annually and consists of just two exchange-traded funds (ETFs): iShares Canadian Bond Index ETF (XBB) representing bonds, and iShares S&P/TSX 60 Index ETF (XIU) representing equities.

So far the decision to hike the allocation to equities during the rebalancing in December is paying off. But we shall see what ultimately unfolds as 2009 wears on. For more details on the OMP, check out the December 18th article on the last rebalancing.

If the market has historically yielded an average 8% to 10% annually over the long run, then borrowing to double exposure to the market would return over 16% to 20% a year (before expenses) to the long-term investor.

Buying stocks on margin has its problems, of course. Interest rates on debt cut into the returns. And if the investor doesn’t have the cash or nerve to respond to margin calls during market corrections, the approach loses its advantages.

Leveraged exchange-traded funds (ETFs) offer fresh hope for the leveraged indexing approach. They don’t have margin calls. And costs appear to be low – annual fees are in the vicinity of 1%. An example is the ProFunds Ultra S&P 500 ETF (SSO), which delivers twice the daily performance of the S&P 500 Index.

Alas, there are substantial caveats on using leveraged ETFs for long-term investing. Tristan Yates of investment advisory Index Roll explains them well. They are also summarized in this article.

A solution may be to rebalance one’s position in a leveraged ETF. As it goes down an investor buys more and as it goes up, they sell off units. This can offset the change in market exposure due to the daily rebalancing that the fund has to do to maintain its leverage factor of two.

The Horizon BetaPro family of leveraged funds offers a “rebalancing tool” on their website for such a purpose. I asked Tristan Yates what he thought of it.

“Using the term ‘rebalancing’ might make you think that you’re maintaining your original index exposure over time,’ he said, “but that’s not the case.” It only directs investors to make up half the loss of exposure. If the index falls $1, investors take losses of $2 and index exposure falls $2. “If you wanted to keep the exposure constant, you would have to contribute $2….” But the tool just asks for $1.

It provides protection but just half way against the constant leverage trap. Investors could conceivably then rebalance with double the amount the tool tells them. That way the leveraged ETF should be more assured of returning close to twice the index (before fees) over long periods.

A challenge, though, is the sums involved when extreme situations arise. If the index falls 40% to 50% over time, the amount to be added to the ETF according to the tool (without doubling up) “could cumulatively equal or perhaps even exceed the original investment,” Mr. Yates warns.

So, annual average returns of 16% to 20% (before fees) may be possible but getting there may require more emotional and financial discipline than most investors have. And after fees, including the fund’s transaction fees etc, the net return might come in closer to 12% to 16% a year. That’s better than unleveraged ETFs but is it worth the hassle? Thoughts anyone …?

If you are increasing your allocation to equities by purchasing mutual funds, you may get hit with taxable year-end, capital-gains distributions. And they can be significant this year because many funds in once-hot sectors like emerging markets and commodities took a lot of profits earlier in this year.

The Wall Street Journal gives two examples from the Oppenheimer fund family: its Developing Markets fund has capital gains of nearly 20% of net asset value for the first nine months of 2008; its Global Opportunities fund has capitals gains of more than 11% of net asset value.

Most mutual funds by now have projections for their year-end distributions and have either published them or will disclose the information on request. So check with the funds before buying and go with the ones planning lower distributions, ceteris paribus.

Year-end capital distributions also provide another reason for selling a loser fund for tax-loss reasons. You’ll not only get a capital loss to offset capital gains but avoid the extra tax hit in December. And if you have a choice of funds to sell, pick those headed for big distributions.

You may be reluctant to sell because you regard the position as a long-term holding and fear the price will jump before you can buy back in after the 30-day waiting period (required to avoid the superficial-loss rule). In that case, you can buy a proxy such as an exchange traded fund, or switch to a similar mutual fund with no planned distributions.

Yes, it’s time to stop acting like a deer in the headlights. While one shouldn’t be checking their account everyday during a bear market, they still need to review their portfolio to take steps to position it for the future.

“It’s not the time for inaction,” Warren MacKenzie, President of Second Opinion Investor Services Inc., states emphatically. Here are three things to do:

1. Harvest tax losses in taxable accounts to claim against past/future capital gains for tax purposes
2. Rebalance portfolio since your asset allocation has likely moved considerably off target (buy low and sell high principle)
3. “Look across the valley and remember … have the courage to invest,” as Mr. MacKenzie notes.

Bear markets are also times when investors begin to think about switching advisors. Does your advisor seem to be hiding from you and is your portfolio down a lot more than expected? That could show your advisor has put you into the wrong investments for your risk tolerances or that they did not explain the risks to you well.

“There is a natural tendency for advisors to “let the winners ride” instead of rebalancing during a bull market,” says Mr. MacKenzie. “And with such a long and strong bull market coming to an end, it’s possible you went into the bear market with an asset allocation that was not the right one for you.”

There are plenty of other model portfolios around. Here are more Canadian examples. Here are more U.S. examples. Canadian Capitalist has the Sleepy Mini Portfolio and even yours truly has the One-Minute Portfolio.

One thing I find interesting is how top active investors recommend passive indexing for most investors. You can’t find better endorsements than that.

“Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees.” Warren Buffett, CEO of Berkshire Hathaway Inc. (1996 shareholder letter to investors)

“Most investors would be better off in an index fund.” Peter Lynch, former star manager of Magellan Fund (Barron’s interview, April 2, 1990)

“I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities.” Benjamin Graham, father of value investing (1976 Financial Analysts Journal interview).

“Most of my investments are in equity index funds.” William F. Sharpe, 1990 Nobel Laureate in Economics (1998 Business Week interview)