(Ryan Mer)
If you are like the majority of investors, you probably have more than one security in your portfolio. Maybe you are equally weighting a basket of 30 high quality stocks. Maybe you’re nearing retirement and considering the classic 60/40 portfolio – a portfolio that allocates 60% to a broad-market equity index fund, like State Street’s S&P 500 ETF Trust. (NYSEMKT: SPY), and 40% to a total bond fund, like Vanguard’s (NASDAQ: BND).
Regardless of what you hold, you probably have a target allocation in mind that you want to maintain. You do this by rebalancing your portfolio at fixed intervals – sell the best performing investments and buy the worst performing each month, quarter or year – so that your investments are reset to their original allocations.
However, you might wonder if your systematic approach to rebalancing is sufficient to reduce the effects of luck on your portfolio performance. Does it matter when you rebalance? And if so, what can you do about it? Let’s dig deeper.
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What is the time rebalancing chance and why is it important?
To spare you the suspense, when you rebalance Is affect portfolio returns – and this is true even if you rebalance at regular times. To illustrate this point, consider two portfolios, A and B. Each holds the same securities with identical target allocations: 50% SPY and 50% cash. The portfolios are rebalanced annually – A is rebalanced each January and B is rebalanced in June. In other words, these two portfolios are the same except when rebalanced.
Even so, A and B will perform differently, only because they are rebalanced in different months. Market performance in the interval between the rebalancing dates of these two portfolios, when one portfolio temporarily has a higher allocation to SPY than the other, will cause A to outperform B (or vice versa).
This is the essence of what Faber (2013) and Hoffstein (2015) call the timing rebalancing chance, and it universally afflicts all rebalancing strategies. Whether you rebalance 30 handpicked names for equal weight or between stocks and bonds in a 60/40 portfolio, the chance of rebalancing will impact your portfolio’s return profile.
And this is no small task. The effect of luck on a 100 stock portfolio rebalanced twice a year can be one to four percentage points a year, but that’s just the start. Luck at the moment can have a permanent impact on terminal wealth to the tune of thousands or even millions of dollars, depending on the initial value of your portfolio and your time horizon.
What can you do about it?
Fortunately, there are several things you can do to minimize the impact of the sync chance. Concretely, you can:
- Rebalance more frequently. The effects of time luck diminish as you rebalance more often, as markets are less likely to experience large changes over shorter time periods. A portfolio rebalanced daily will experience less chance of timing than a portfolio rebalanced annually.
- Hold more investments. A well-diversified portfolio of 1,000 stocks will have less chance of rebalancing than a concentrated basket of just ten stocks.
- Reduce portfolio volatility. Less volatile investments, such as a collection of quality bonds, are less affected by current luck than more volatile ones, such as a leveraged ETF portfolio.
However, none of these fixes are without drawbacks. Frequent rebalancing increases transaction costs, reducing performance – a more diversified portfolio suffers from the same problem as well. And opting for less volatile investments won’t solve this problem either, since you are sacrificing the higher potential return you could earn with more volatile strategies.
In short, each of these luck mitigation strategies will cost you something, and you need to carefully consider whether they are worth it.
Take-out
The chance of rebalancing affects all rebalancing strategies and almost all portfolios. As a systematic investor, you want to protect your portfolio from unwanted changes in wealth, but a routine and regularly planned rebalancing strategy, while an integral part of a prudent investment strategy, is not sufficient for it. alone to “protect the luck” of your wallet. Nonetheless, diligent investors who engage in thoughtful analysis using their newfound knowledge of timing luck rebalancing are more likely than not to get away with it.
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