Current Thinking

Portfolio Rebalancing in the Recent Market Environment

Recent stock market highs have made it tempting for investors to let their portfolio “ride” the trend of these returns without adjusting their asset mix. How can investors keep their portfolio allocations from drifting too far from their desired target allocations and potentially increasing their exposure to sudden market downturns? A well-known form of adjustment is known as rebalancing. Rebalancing can be defined as reducing the percentage of the portfolio in the higher performing asset class and increasing the percentage in the underperforming asset class. Rebalancing can be done either on a calendar basis (monthly, quarterly, annually) or when a threshold is exceeded (e.g. when stocks appreciate by 10% or more versus bonds over a 4-week period). Given that current equity markets are highly valued with the added specter of higher interest rates and geopolitical risks, there may be several potential benefits to rebalancing. These include maintaining diversification over the long term; maintaining one’s asset mix within reasonable ranges; and reducing the vulnerability of the portfolio to unexpected market corrections.

While the benefits of rebalancing are always sensitive to the time period involved, it is useful to illustrate a simple example of a target 60% stock (S&P 500 Index) and 40% bond (Bloomberg Barclays US Aggregate Bond Index) portfolio. The chart below summarizes several rebalancing scenarios:

No RebalancingMonthly RebalancingAnnual (End of Year) Rebalancing
Time Period:Annualized ReturnReturn /RiskAnnualized ReturnReturn /RiskAnnualized ReturnReturn /Risk
9/2012-8/2017 (5 years)9.47%1.589.46%1.639.58%1.65
1/2008-12/2009 (2 years)-3.88%-0.30-3.94%-0.26-3.05%-0.21
Target Stock/Bond Mix60%/40%60%/40%60%/40%
Ending Stock/Bond Mix67.8%/32.2%59.9%/40.1%62.3%/47.7%

Risk is defined as the annualized standard deviation of returns.

Overall, the greatest benefit (higher annualized return and higher return/risk) resulted from annual rebalancing as opposed to no rebalancing or monthly rebalancing. This included the 2008-09 period when there was significant market volatility due to the 2008 financial crisis. Comparatively, monthly rebalancing resulted in the least amount of asset mix drift (actual versus target allocation); however, an additional consideration with monthly rebalancing is that it may result in significant trading costs and tax impacts. The greatest asset mix drift resulted when there was no rebalancing. Annual rebalancing resulted in some drift, but much less drift than with no rebalancing.

In summary, it makes sense to look at one’s portfolio allocation versus one’s target allocation on a periodic basis. In the above illustration, a once per calendar year rebalancing had the potential to add value on a risk-adjusted basis, and importantly, to guard against drift in the portfolio’s asset mix due to gains which may reverse in the future.

NOTE: Information presented herein is for discussion and illustrative purposes only and is not a recommendation or an offer or solicitation to buy or sell any securities. Past performance is not a guarantee of future results. 

About Frederic Slade

Frederic Slade is Assistant Vice President and Senior Director, Investments at Pentegra Retirement Services. He joined Pentegra in May 2007 as a Senior Analyst in the Investment Department and became Director-Investments in January 2013. He is responsible for managing over $1 billion in internal bond portfolios and providing asset/liability studies, analytics and product strategy for Pentegra’s Defined Benefit and Defined Contribution Plans. Mr. Slade is also a frequent contributor of economic and financial market blogs to Pentegra’s Talk to a Specialist website and the financial media. Prior to joining Pentegra, Mr. Slade was a Senior Quantitative Analyst at Citigroup Asset Management, providing asset allocation and quantitative stock screening for mutual fund products. Prior to Mr. Slade’s tenure at Citigroup, he was an Investment Manager at NYNEX Asset Management (now Verizon). At Verizon, Mr. Slade was responsible for asset allocation and planning for its $15 billion Defined Benefit pension fund. Mr. Slade holds a Ph.D. in Economics from the University of Pennsylvania and a CFA, and is a frequent presenter at industry seminars and conferences.