Investing involves tradeoffs. Perhaps the primary tradeoff is between expected return and expected risk.

Investing is difficult, at least in part, because we can never be sure, when we look into the future, if our expectations about future return or future risk are correct.

Given that investing is a balancing act between expected return and expected risk, then it would seem, that rebalancing is a no-brainer.

But it’s not really so simple. Below, we’ll see why.

Rebalancing is the process of buying or selling assets (or asset classes) in a portfolio for no other reason than to bring the portfolio asset allocation back into line with some pre-determined ratio of asset classes.

The 60-40 Portfolio

One classic portfolio is the 60-40 portfolio, in which 60% of the assets are allocated to “the stock market” and 40% to “bonds.”

The idea of portfolio balance emerges, implicitly, from the concept of market efficiency. The efficient market hypothesis posits that investment returns are primarily a reward for bearing risk. Thus, according to the theory, riskier assets will have higher expected returns than less risky assets.

For intellectual and practical tractability, many theoreticians, and practitioners, simplify the world into asset classes. So, for example, the thousands of US stocks are summarized by the S&P 500, and the hundreds of issues of US treasuries (and the thousands of bonds) may be summarized by the benchmark US Treasury 10 year.

Those two markets – the S&P 500, and the US Treasury 10-year note – provide a natural and easy to understand background for looking at the performance of the 60-40 portfolio.

Rebalancing and the 60-40 Portfolio

The most widely available historical data sets for US investment returns start in the 1920s before the great crash and the depression, and provide annual return data. For example, NYU makes certain return data available free, in an easy-to-use format.[1]

We use these data in this post to look at rebalancing in an historical context.

The idea of the 60-40 portfolio (or any “balanced” portfolio) is that the portfolio is managed to keep the desired asset allocation. In the case of the 60-40 portfolio, that would mean rebalancing the portfolio to keep it close to 60-40.

Using the NYU data, we simulated a portfolio that started in 1928, and was 60% in stocks and 40% in bonds. We then rebalanced that portfolio every year to bring it back to the 60-40 allocation.

In this theoretical, no-tax environment, $100 invested at the end of 1927 would have grown to $226,000 over the next 97 years, assuming that each year the portfolio had been rebalanced back to the starting 60-40 asset allocation. Here’s a graph.

What would have happened if the initial $100 had been invested 60% in stocks and 40% in bonds, and the returns (mostly dividends) from the stocks had been reinvested in stocks and the returns from bonds reinvested into bonds? Then the $100 would have grown to nearly $600,000 over the 97-year period.

Here’s that graph.

Why Rebalance

Over the last century, in the US, rebalancing between stocks and bonds would have cut your total ending portfolio by more than half.

Why, then, rebalance?

The argument for rebalancing rests on the view that risk is identified with portfolio volatility.

Looking back at the above record, few people, from today looking backward, would select the rebalanced portfolio.

But as we live life going forward, the idea of a less volatile portfolio has great appeal to many people. And for professionals who promise to deliver a certain product, such as a balanced fund, the choice is made for them.

Taxes

We’ve ignored taxes. It seems to us that if you have a taxable account, the tax costs of rebalancing are likely to outweigh the benefits of lower risk. If you sell an asset that has gone up, you will likely incur a tax. In a taxable account, if you desire to maintain a portfolio weighting such as 60-40, it likely makes sense to do so, or attempt to do so, by adding new funds (such as annual savings) to the underweighted asset class.

For large accounts that are not retirement accounts, and in which there is a desire to trade, or rebalance, or realize gains, it may make sense to consider solutions such as a tax-exempt Stock Diversification Trust. The effective use of such trusts can provide a tax-exempt environment in which to manage the portfolio, thus providing a greater ability to manage risk while minimizing the tax cost of doing so.

For more information on the use of Stock Diversification Trusts, reply back to this email or click here to request our case study on Appreciated Stock.

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[1] https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html