When Rebalancing Creates Higher Returns—and When It Doesn’t (2024)

Tactical Rebalancing

I talked last week with Elizabeth O’Brien of Barron’s about portfolio rebalancing. Her article discussed timing. Given the stock market’s recent strength, especially among the leading technology stocks, might retirement investors be best served by trimming their winners, reinvesting their gains into such relative laggards as bonds, value stocks, and real estate?

They might indeed. To be sure, identifying opportune trades is easier said than done, but now would seem to be a sensible moment for reassessing one’s growth-stock exposure. The following chart depicts the difference in price/earnings ratios between the Morningstar US Growth and Morningstar US Value Indexes over the past 15 years. Growth stocks have occasionally commanded an even higher premium than they do today, but not often.

Strategic Rebalancing

This column, however, addresses a different topic: The ongoing benefits (or not) of rebalancing. The first point is that if two assets have identical long-term total returns, rebalancing always leads to higher profits. That is a mathematical certainty. Rebalancing means reallocating from a winner into a loser. If each investment finishes at the same level, then those relative standings must reverse. The trade will inevitably improve the portfolio’s result.

The second boon is similarly obvious. The greater the disparity between the assets’ returns, the greater the rebalancing bonus. If one investment rises by 5% while the other makes 3%, not only will the amount of the rebalancing trade be minuscule, but so will its benefit, as there is little lost ground for the portfolio to recapture. (To reiterate, this comment assumes that the assets have the same long-term return.) On the other hand, reallocating from an asset that gained 100% to one that dropped 50% is highly consequential.

Rebalancing is ideally suited for investments that dance to different beats but which are likely to end up in similar positions.

Study Number 1: A Hypothetical Case

To demonstrate the above precepts, I created five portfolios, assessing their outcomes from January 2015 through June 2024. For each portfolio, the initial allocation was equally divided between the following two investments.

1) US stocks and US cash

2) US stocks and US bonds

3) US growth stocks and US value stocks

4) US stocks and foreign stocks

5) US stocks and gold bullion

In truth, these assets posted very different long-term totals. For example, US stocks tripled their initial capital, while US cash barely budged. However, because this exercise aims to show the rebalancing effect for assets that have the same eventual returns, I adjusted each investment’s totals. While retaining the asset’s overall performance pattern, I modified its annual outcomes, to create a 6% annualized total return over the 9.5-year period.

I then compared the results for two versions of each portfolio. The first version let the initial positions ride, without making any subsequent trades. The second version featured annual rebalancing, occurring each January.

Mixed Gains From Rebalancing

The earth still revolves around the sun, steam remains hotter than ice, and light continues to move at 186,000 miles per second. So, too, does rebalancing improve performance, when all the portfolio’s assets have the same long-term gains. However, the rebalancing benefits are not always large. With this study, rebalancing between 1) US stocks and bonds, and 2) US and foreign stocks produced less than 10 basis points of extra annual returns.

The reason for the fizzle was simple: Those assets behaved too similarly. Never mind the squiggles in their returns; as I wrote, such differences are unimportant. Rebalancing seeks big disparities. However, the year in which US stocks got clocked, 2022, also featured by far the worst performance for bonds. The same principle applies to foreign stocks, which mostly moved in tandem with domestic equities. They gave little bang for the rebalancing buck.

In contrast, while value and growth stocks might seem the unlikeliest rebalancing opportunity, as they are subsegments of the same investment universe, their fortunes have substantially diverged. In 2022, the Morningstar US Growth Index shed 36.7% of its value, while the US Value index lost less than 1.0%. That was the opportunity that rebalancing seized.

Study Number 2: Rebalancing in Real Life

All fine and good for illustrating rebalancing’s logic. However, in this universe, as opposed to the alternative world of hypothetical studies, assets don’t regularly record the same long-term returns. Which begs the question: Over that same 9.5-year period, using the same portfolio assumptions, what was the actual benefit of rebalancing?

Not much, as it turns out.

Swapping between growth and value stocks remained helpful. Otherwise, though, rebalancing reduced the portfolios’ returns. Dividing between stocks and gold worked fairly well, as although gold’s annualized return was lower (6.5% versus 12.4% for domestic equities), the two asset classes behaved differently enough for rebalancing to close most of that gap. But, as previously written, foreign equities supplied scant diversification, while cash and bonds earned too little. Rebalancing from a high-performing asset into one that goes nowhere is almost always a losing strategy, regardless of the return pattern.

There are two objections to this observation. One is that investors cannot know ahead of time which assets will succeed. (If they did, this discussion would be moot, as there would be no need to diversify.) The other rejoinder is that even if one believes that aggressive assets will eventually outgain safer options, abstaining from rebalancing carries an investment cost. Consider a portfolio consisting of stocks and cash. If those assets remain untouched, over time equities will likely grow their weighting. The portfolio will have posted higher returns than otherwise—but it will also have become riskier.

Wrapping Up the Merits of Rebalancing

This column aims neither to praise nor bury rebalancing. Its goal instead is to clarify the assumptions that underlie the practice. Assuming no transaction costs—tax considerations are another matter—rebalancing is ideally suited for investments that dance to different beats but which are likely to end up in similar positions. The leading example consists of growth and value stocks. Rebalancing between US and foreign stocks also makes sense, unless one believes that the former will continue to post substantially superior returns.

The case for rebalancing between stocks and less-lucrative assets is less clear. Rebalancing under such conditions is not a mistake. The rebalanced portfolio may forgo some gains, but it will not surrender its relative safety. Consequently, the risk/return trade-off remains intact. That said, there may, in fact, be a trade-off, rather than an unambiguous benefit. Rebalancing can provide a free lunch—but, as this column has shown, it does not always do so.