Saturday, 15 December 2007

Rethinking Rebalancing Policy: Is the Rip Van Winkle Model the Best?

Rip Van Winkle is the fictional character who goes to sleep one day and wakes up twenty years later to discover that his principal problem in life - his wife - has died and he can now live an indolent life in peace. Is a similar approach the best for investors who use a portfolio approach?

Larry Macdonald has noted in his blog posting titled "No need for annual rebalancing" on Dec.3, 2007 a fascinating and shocking study "Optimal Rebalancing Frequency for Bond/Stock Portfolios" by David M. Smith and William Desormeau in the November 2006 Financial Planning Journal that seems to suggest an "almost never" approach is best. They studied the two popular approaches to rebalancing: at regular intervals (monthly, quarterly, yearly etc), or based on percentage deviation of asset values from the target (1%, 5%, 10% etc). They did this for a wide range of bond vs stock portfolio proportions using US data for the long period of 1926 to 2003.

Their conclusions are these:
"Rebalancing frequency and threshold level are associated with significant differences in portfolio scaled returns. We show that this is true across a wide range of policy weights. From the perspective of both frequency and threshold levels, patient rebalancing policies tend to dominate quick-trigger policies, even before trading costs and taxes are considered. If such costs were taken into account, the advantage in favor of patient policies would be even more dramatic."
Scaled returns means returns that take account of returns relative to risk. Policy weights means the bond vs stock mixes. The threshold means that if bonds are meant to be 40% of the portfolio and the threshold is 10%, then rebalancing was only done if bonds went down below 30% (or above 50%) not when bonds went below 36% (10% of 40%).

They found that the optimal frequency using a time trigger was 44 months, or 3 years 8 months! For percentage deviation triggers, 5% or more was best; 10% was best or second best for about half the portfolio mixes (see table 2). And that is before transaction costs! I am bit puzzled by Figure 4, which if I read it right says that if one had adopted a 10% trigger for rebalancing, then no matter what the portfolio composition, during the whole period of 1926 to 2003, one would NEVER have had to rebalance. Or maybe, the graph is hard to read and it is less than 25 trades in 78 years. Either way that's astounding. Hello Rip, I see you've been a successful investor during your wee nap. Given that equities produce superior returns when calculated over long periods, I wonder how the portfolio could never have deviated that much from the targets.

Maybe the best rebalancing policy is above 10% deviation from target and only if new money added to the portfolio, or withdrawals from it, don't take care of bringing the portfolio allocation within the range. Isn't it good to know that being lazy can be a virtue?

5 comments:

Preet said...

I used to subscribe to Globe Hysales and I did a similar (albeit less formal) analysis on rebalancing frequency.

In the end I found that once every 2 years was more than plenty, but if situations present themselves (i.e. +10% deviation from your allocation) then it would make sense to rebalance then as well.

I think the lack of rebalancing frequently allows for certain asset classes to have a bit of a run.

If you constantly rebalanced and found that, for example, Canadian equities kept going overweight - then by rebalancing your Cdn equities downward, you have less of your portfolio exposed to the asset class "on a run".

CanadianInvestor said...

preet, the idea of a run having some momentum is put forward by the authors as a possible explanation for their findings that it is better to rebalance infrequently or not at all.

Preet said...

Thought it might. But I echo your question about equities having performed better than fixed income in the past long term - one would think that eventually the maximum allowed deviation would eventually have been reached...

...any further insight to that?

Larry MacDonald said...

Like your blog. I’m doing an article for the Globe and Mail on rebalancing and was looking for people willing to describe how they are rebalancing their portfolios (if any). Would you be interested in participating? Need a response by 4PM Dec 24 due to press deadlines.
Larry MacDonald

CanadianInvestor said...

Larry, nice to have you visit and thanks again for writing about that article. I'll post my revised thoughts on rebalancing tomorrow.

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