"An In-Depth Look at Portfolio Rebalancing Strategies"
Comprehensive look at the issue of rebalancing by a leading Financial Planning. Covers what rebalancing is, its benefits, different methods (including time-based and threshold-based), and other aspects for consideration. Key finding for RP investors: 20% (relative) threshold rebalancing looks best.
Read the original:
Important Points for the RP Investor:
This clear and crisp overview of rebalancing is meant for financial planners but accessible to DIY investors. Kitces is sort of the Master Financial Planner - he is the one who teaches the financial planners, and the person to whom they look for help with difficult questions. His site has a lot of resources, and one handy trick for me has been to google his name and the thing I want to know about; you can always count on his work. It’s great to have this resource where he draws on the academic research, considers typical issues and questions that come up, and then puts it all into a logical and useful guide.
It isn’t a paper on Risk Parity per se, but since RP portfolios rely on asset allocation strategies, and you’ll likely need to rebalance in some way to maintain such a strategy, I thought it worth summarizing and including as an RP resource. The entire paper is worth a read, by the way, and is comprehensive without being excessive (20 pages).
The paper is a great expansion of topics I've covered earlier in the blog: here is my first post with the rebalancing worksheet, which has some of the basics, but as for the worksheet itself, I have updated it, and here is the most recent version. You may also like this post about strategic asset allocation, which explains one of the reasons you’d want to rebalance in the first place.
Important Points for the RP Investor:
Page 1: great executive summary of the whole paper. If you just have 2 minutes, read this!
Pages 2 and 3: explanation of what rebalancing is and its two key purposes. First, it gets the portfolio back in sync with original asset allocation. This is the “managing risk” function. Second, rebalancing is a structural way to ensure the investor is buying low and selling high. This is the “enhancing return” benefit, and is explained in greater depth on pages 4 and 5.
Pages 5 and 6: look at hypothetical cases of rebalancing, and whether there is always a rebalancing “bonus,” or just sometimes. Kitces quotes William Bernstein’s finding that “the higher volatility of assets and the lower their correlations (italics in original) – creating even more rebalancing opportunities – the greater the potential ‘Rebalancing Bonus’ will be.” This is crucial for RP investors who search far and wide for low and negatively correlated assets, with multiple volatility profiles. Put a pin in this idea.
Pages 6 to 8: Discussion of the optimal rebalancing time intervals, which is a tricky question: too frequent and you have lots of transaction fees, time spent, and may sell of rising funds too early; not frequent enough and you’ll miss lots of peaks and valleys as assets return to the mean over time. Kitces relays that the research has been mixed, with some saying intervals of 3-4 years were best, some saying anything lower than one year was ineffective, and one saying that it didn’t really matter one way or the other.
Pages 8 to 12: Presentation of an alternative - allocation tolerance bands that prompt rebalancing when a certain asset is a certain amount above/below its target. Kitces walks the reader through various possibilities, but settles on a recommendation that the best rebalancing band is a relative threshold of 20% off the original weighting. Put a second pin in this idea - we’ll come back to it.
Pages 13 through 16: Another way to handle rebalancing is simply to use new contributions to buy what is low and/or necessary withdrawals to take away from what is highest. This is the most direct way of rebalancing, but it might not be enough, if the money going in or out isn’t large enough to make a meaningful impact on the allocations. This method, which I guess we can just call simple rebalancing, is how I have handled the test portfolios (check out the link to rules for portfolios at the bottom). It seems to be working fine for the more stable portfolios with few assets, but is proving to not really matter for the more aggressive portfolios with more assets. In the RPC Growth portfolio, for example, there were assets that were -55%, - 57%, +69% and even +111% beyond their target allocations! Put a third pin here.
Pages 18 and 20: Covers the two types of benefit that rebalancing can bring: economic and psychological. For economic benefits, Kitces quotes a paper by Daryanani which found a rebalancing bonus of 40 basis points. This may vary, certainly, and is far from a guarantee, but suggests that one way to boost perpetual withdrawal rates is through rebalancing intelligently. I find the psychological benefit of rebalancing even more compelling in that it provides a structural way to make sure assets are sold at their higher points and bought at their lower points - the essence of investing. Kitces writes that investors who have
A strict, numbers-based target allocation scheme with rebalancing has allowed me to skirt the stress of market timing. I can simply follow my numbers which tells me X is outsized and Y is cheap.
Page 20: wrap-up of major points and discussion of some talking points for financial advisors as they work with clients.
Returning to the pins we placed earlier, the big takeaways from this paper are that rebalancing is advisable for portfolios consisting of volatile assets with low or negative correlation, and that a 20% tolerance band, in relative terms, seems to work best. The RPC Growth portfolio fits the description of a portfolio that would benefit from rebalancing to a “T”, so I’m going to be starting a test using that portfolio (plus the RPC Income) to see how a 20% rebalancing threshold will impact the portfolio. Stay tuned for more.
Other Resources Related to this Paper:
- Michael Kitces is like his own eco-system in Financial Planning, and his website is the place to start:
- His primary audience is other financial planning professionals, so naturally, some of the discussions and topics are pretty high-level. At the same time, Kitces is a clear and persuasive communicator, so his work is still pretty accessible if you are beyond the basics.
- He also has a podcast, but it’s not really meant for average investors, and I wouldn’t recommend it, actually. It’s a lot about the business side of managing a financial planning firm.
- Kitces draws on a few academic and industry papers on rebalancing in the course of his piece. I haven’t read them, but it seems like this may be a good one for a future RP Resources post: