A lot has been said about the importance of rebalancing. In fact, we at Hardesty Capital have said a lot about it. But let’s take a step back. In investing, every action taken is about managing risk versus return. Investors choose what level of risk they are willing to accept, knowing that with more risk they can expect higher return. The opposite is also true: less risk means less return. When investing in individual securities, research is performed to determine if that relationship is misaligned, that is, to look for higher returns with less risk. However, when talking about entire asset classes and their place in a portfolio, all that we need to focus on is managing risk, reward, and time. 

When rebalancing a portfolio to some target, for example 60% large cap stocks, 10% international stocks, and 30% bonds, all one really does is realign the risk/reward dynamic of his portfolio. Say that international stocks do very well one year and end up as 15% of the portfolio. Since international stocks are generally considered a riskier asset, the overall portfolio is now riskier. Rebalancing brings this risk back to the target level.

Some articles have been written saying that you don’t need to rebalance at all: the authors’ studies show that, in fact, not rebalancing leads to higher returns! To that we say of course it does: you’re letting the high-risk, high return assets pile up. To maximize return with no regard to risk, one would simply have 100% of the riskiest asset (international stocks in the above example). If the not-rebalanced portfolios seem appealing, then the initial targets may have been chosen incorrectly.

Where does time fit in? As time passes and retirement approaches, there isn’t time to make up lost ground in the event of a major drop in value of the portfolio. Said simply, you can’t afford to take as much risk. So, as time passes, targets may shift toward less-risky assets.

It’s helpful to keep this maxim in the back of your mind when making investments: If you are getting higher returns, you are taking more risk. Lower returns (should) mean lower risk. Not recognizing this simple fact has led to the collapse of many portfolios from the loss of “sure-thing” investments. On the other hand, recognizing the relationship between risk and return can help you frame all of your investment decisions, including when and whether to rebalance your portfolio.

We performed a study of different splits between stocks and bonds over twenty-year periods. In it, we looked at how rebalancing affects risk and return. Our results are below. The Sharpe Ratio is used to measure how much return is earned per unit of risk taken. That is, a higher Sharpe Ratio means more return for less risk.

Source: FactSet, Hardesty Capital Management Calculations
*Note that these are arithmetic averages of the four periods studied, meant to illustrate the average return expected in a given twenty year period.