This article was written by the Institutional & Insurance Investments group at Brown Brothers Harriman. For more articles, please visit the Institutional Asset Management site or the Insurance Asset Management site.

October 18, 2002

What Are the Benefits of Rebalancing?

Raghu Ramachandran

Once you have selected an asset allocation, you may think your job is done. However, the first holdings report you receive will have an allocation different from the approved allocation. Because different sectors have varying returns, the allocations will move separately. In fact, you should be surprised if the actual allocation matches your selected allocation.

Does this mean that you should let your portfolio allocation go wherever it may? Certainly not! You selected an allocation because it provided a certain level of return at a certain level of risk. Deviating from the suggested allocation could mean you have more risk or less return. However, constantly rebalancing your portfolio can be expensive. To limit the deviation from the selected portfolio and constrain you expenses, you need to establish and maintain a strict rebalancing strategy.

The following is an example of a rebalancing strategy:

Sector
Minimum Trigger
Minimum Target
Selected Allocation
Maximum Target
Maximum Trigger
Cash
4.0%
4.3%
5.0%
5.7%
6.0%
Bonds
70.0%
71.7%
75.0%
77.7%
79.0%
Stocks
16.0%
17.3%
20.0%
24.0%
26.0%

The middle column is the selected allocation for each sector. As long as the allocation is between the two trigger points, the allocation to the sector does not need to be adjusted. But once the allocation reaches the trigger point, you should rebalance to the target. For example, as long as Cash is between 4.0% and 6.0%, the Cash allocation is acceptable. However, if the allocation drops below 4.0%, then Cash should be increased to 4.3%; if Cash goes above 6.0%, then is should be reduced 5.7%.

While much has been written on the methodology and theoretical benefits of rebalancing, not much has been done to show the practical benefits of a strict rebalancing strategy. To demonstrate the practical effects, we created the following example. Using the selected allocation above, we went back 10 years and considered how different rebalancing strategies would affect the outcome.

Our first rebalancing strategy was to do nothing. Once funds were allocated to a sector, they never left the sector. Our second strategy was to use the same portfolio but we review the allocation once a year to see if the allocations were outside the bounds. If they were, we rebalance using the guidelines above. The third strategy was similar to the second, except we analyzed at the portfolio every quarter. The final strategy analyzed the portfolio every month. The following graph plots the performance of the portfolio under the varying rebalancing strategies.

The point on the lower right is the result of not rebalancing. The three points on the upper left show the effects of rebalancing at various frequencies. Each of the these strategies out performed the buy and do nothing strategy. Thus, following a rebalancing strategy is an improvement over not having a rebalancing strategy.


Mr. Ramachandran is a Senior Portfolio Strategist.
raghu.ramachandran@bbh.com

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