One of the best parts about Twitter is that you can follow super smart people and just read their interactions. For instance, yesterday I was creeping on Jeremiah Lowin, Jake from Econompic and Corey Hoffstein. These are three super smart finance guys who were going back and forth about the rebalancing bonus which was made famous by William Bernstein.

I will let you assess their comments as you wish, but I have a A LOT to say about rebalancing because it’s so central to everything I profess so here’s my general thoughts on the idea of a “rebalancing bonus”.

The basic idea of a rebalancing bonus is that you will rebalance a portfolio away from higher risk assets when they’ve gone up in value and rebalance towards lower performing assets. It is, in essence, a systematic way of selling high and buying low. For instance, when your 50/50 stock/bond portfolio grows into 60/40 you want to rebalance back to 50/50 and sell the stocks to rebalance back towards the lower risk and lower performing asset because now you’re overexposed to the higher risk asset.¹ That’s simple enough. But why does this generate what Bernstein calls a rebalancing bonus?

There’s a lot of debate about why this works or whether it works at all. And in fact, the results are quite different in nominal and risk adjusted terms. If we look at the data since 1940 a portfolio of 50/50 stocks/bonds will do slightly better on a risk adjusted basis and does 1.5% worse per year when rebalanced.

There’s a bunch of interesting elements within these results:

  • Why is there a risk adjusted rebalancing bonus? The nominal results are obvious – stocks tend to beat bonds so a portfolio that becomes more and more overweight stocks will tend to do better on average. The superior risk adjusted returns are a point of contention in financial circles though. I think it’s pretty simple – the Global Financial Asset Portfolio is a lot more stable than most people think across time. It is currently 46% stocks and 54% bonds, but has been pretty close to a 50/50 portfolio since 1960 when reliable data is first available. So it makes sense then, if this is “the market” portfolio that rebalancing ever closer to this portfolio will generate a more efficient type of return. In other words, rebalancing away from stocks when they grow disproportionately in your portfolio is another way of rebalancing back towards the market portfolio.
  • Print Friendly, PDF & Email