Does rebalancing improve performance or just reduce risk?

Does Rebalancing Improve Performance or Just Reduce Risk💡 Definition:Risk is the chance of losing money on an investment, which helps you assess potential returns.?

Investors often grapple with the question of whether rebalancing their portfolio enhances returns or merely controls risk. The short answer is that while rebalancing primarily aims to maintain your desired risk level, it can also modestly improve performance under certain conditions. Understanding how and when to rebalance💡 Definition:The process of realigning your investment portfolio back to your target asset allocation by buying and selling assets. your portfolio can make a significant difference in achieving your financial goals.

Understanding Rebalancing: Balancing Risk and Returns

At its core, rebalancing is about risk management💡 Definition:The process of identifying, assessing, and controlling threats to your financial security and goals.. It involves adjusting your portfolio back to its target asset allocation💡 Definition:The mix of different investment types in your portfolio, determining both risk and potential returns to ensure that you are not taking on more risk than you intended. For instance, if you have a 60/40 equity💡 Definition:Equity represents ownership in an asset, crucial for wealth building and financial security.-to-bond💡 Definition:A fixed-income investment where you loan money to a government or corporation in exchange for regular interest payments. ratio and your equities perform well, your portfolio may drift to a higher equity weight, potentially increasing your risk exposure. Rebalancing brings it back to the original allocation.

Key Benefits of Rebalancing

• Risk Control: By realigning your portfolio with your target allocation, you avoid unintended risk exposure. A 60/40 portfolio that drifts to 70/30 due to equity outperformance may face higher volatility than anticipated.

• Capture Volatility: Rebalancing can capture gains from volatility by selling high and buying low. This is particularly beneficial when asset classes💡 Definition:A group of investments with similar behavior, risk, and regulatory profiles (e.g., stocks, bonds, cash). have low correlation and divergent performance.

• Risk-Adjusted Returns: Over long periods, rebalancing often leads to higher risk-adjusted returns, as measured by metrics like the Sharpe ratio💡 Definition:Risk-adjusted return measure. Higher is better. 1.0+ is good. Compares excess return to volatility—rewards returns, penalizes risk..

Different Rebalancing Strategies

Calendar-Based Rebalancing

This method involves rebalancing at fixed intervals, such as monthly, quarterly, or annually. While easy to implement, it can lead to higher transaction costs if done too frequently without significant benefit.

Tolerance-Band Rebalancing

Instead of fixed intervals, this strategy rebalances only when asset allocations deviate beyond a set threshold (e.g., 5%). This can be more efficient in balancing turnover💡 Definition:Revenue is the total income generated by a business, crucial for growth and sustainability. costs and tracking error.

Symmetric vs. Asymmetric Rebalancing

• Symmetric Rebalancing: Targets equal deviation limits above and below target weights, maintaining a balanced risk exposure.
• Asymmetric Rebalancing: Allows more drift on one side, which can unintentionally increase risk by letting equities, for example, drift higher.

Real-World Examples

In 2022, US Growth stocks fell by 36.7%, while US Value stocks lost less than 1%. A portfolio rebalanced between these sub-asset classes would have benefited from buying undervalued growth stocks and selling value stocks, effectively capturing gains from market volatility💡 Definition:How much an investment's price or returns bounce around over time—higher volatility means larger swings and higher risk..

Similarly, a 60/40 equity/bond portfolio without rebalancing could see its equity portion drift to 85% or drop to 45%, exposing the investor to unintended risk levels. Rebalancing helps maintain the intended risk profile.

Common Mistakes and Considerations

Transaction Costs and Taxes

Frequent rebalancing increases turnover, leading to higher transaction costs and potential tax liabilities. It's crucial to balance the benefits of rebalancing with these costs.

Asset Correlation💡 Definition:A value between -1 and +1 that shows how two investments move together—lower correlation improves diversification. and Volatility

Rebalancing is more effective when asset classes exhibit low correlation and divergent returns. When assets move similarly, as seen with US stocks and bonds in 2022, the performance gains from rebalancing are minimal.

Investor Goals and 💡 Definition:Risk capacity is your financial ability to take on risk without jeopardizing your goals.Risk Tolerance💡 Definition:Your willingness and financial ability to absorb potential losses or uncertainty in exchange for potential rewards.

The optimal rebalancing frequency depends on your risk tolerance and sensitivity to costs. Overly frequent rebalancing may reduce risk but at a cost that outweighs the benefits.

Pro-Risk Bias

Certain rebalancing approaches, like asymmetric rebalancing, may unintentionally increase portfolio risk by allowing one asset class, such as equities, to drift higher on average.

Bottom Line

Rebalancing is primarily a tool for managing risk, ensuring your portfolio stays aligned with your financial goals and risk tolerance. While it can modestly improve performance, particularly in volatile markets with divergent asset returns, the costs associated with frequent rebalancing can offset these gains. For most investors, a tolerance-band approach may offer a balanced strategy by minimizing turnover and maintaining alignment with your target allocation. Ultimately, the key is to choose a rebalancing strategy that aligns with your risk tolerance and investment horizon💡 Definition:The period until an investment goal is reached, influencing risk and strategy., ensuring that your portfolio continues to work towards your financial objectives.