Recently a reader emailed me saying he would have enjoyed some specific examples of how various portfolio rebalancing strategies have performed in the past. This email came after the reader read our article on How often and when should you rebalance your portfolio?
In that article, we discuss some potential portfolio rebalancing strategies. You can click on the article above to read them in detail, but here they are in summary form:
- Fixed interval rebalancing – Simple way to rebalance. Rebalance portfolio every year (or some other fixed interval) back to the target allocation.
- Threshold rebalancing – Rather than utilize fixed intervals, rebalance the portfolio whenever the allocation exceeds a certain threshold away from the target allocation (for example, perhaps rebalance a 70/30 portfolio if it gets out of whack more than 5% away from the target allocation).
- Modified scheduled rebalancing – If at the start of a bull market, we might want to let our stocks “run” a bit. In this scenario, we don’t rebalance at all for three years, then begin rebalancing once a year, each year.
- Gradual shift rebalancing – This is a more aggressive approach again assuming that we’re at the beginning of a bull market. It starts with an aggressive 100% equities / 0% bonds allocation then shifts each year more and more towards the target allocation (e.g. 70/30).
So which strategy is best?
That’s not an easy question to answer for a number of reasons. First, mathematical best might not mean best for everyone. Generally speaking, the best strategy is the one that provides adequate returns for you while also letting you sleep well at night. Why aim for the best returns possible if you’re lying awake every night stressed about your strategy? It’s hard to call that the “best” strategy.
But, let’s try and crunch some numbers and see how these various strategies performed over a lengthy period of time and through the tumultuous 2020 coronavirus crash (and subsequent rebound).
Here’s how we set up our test:
- We’re looking at data from Jan 1, 2012 through Dec 31, 2020 (a span of nine years).
- We’re using a 70 / 30 split and to keep it relatively simple, we’re using SCHB and SCHZ. These are two broad Schwab ETFs for equities and bonds exposure.
- We begin with a balance of $100,000 allocated to the target allocation, and we reinvest dividends along the way.
- We measure cumulative return, volatility and Sharpe ratio of each strategy.
A few caveats on the results:
- This is just a single test over a single time period. 2012-2020 is essentially a raging bull market with a really sharp, but quick crash in the final year before recovering and hitting new highs essentially. To properly evaluate these strategies, you would need to look at other time periods too. Perhaps we will do that in a follow up article.
- The data here isn’t perfect. I used monthly closing data for both SCHZ and SCHB. While we used actual dividend data to calculate the effect of reinvested dividends, this isn’t perfect because we didn’t determine the specific day within that month that shares were purchased with dividend proceeds. Close enough for our purposes today.
- Remember that portfolio rebalancing in a market that is basically going up continually (a raging bull market) will lead to lower returns than not rebalancing. If you are rebalancing while stocks keep going up and up, you’re by definition reducing exposure to the asset that is going up and up. So why not just own equities and forget rebalancing? Well you could. But investing is not just about returns. It’s also about risk. Risk matters much differently to people depending on their personal situation. If you’re 25 years old with rich parents that plan to leave you a ton of money, you should probably be putting money into equities and not stressing about bonds. If you’re 85 with a spouse, it probably makes sense to be very concerned with market volatility and manage your returns against risk.
Baseline: No rebalancing
To get a baseline to measure against, we ran our scenario without any portfolio rebalancing efforts. Again this is 70/30 with $100,000 initial value on Jan 1, 2012. $70,000 in SCHB and $30,000 in SCHZ. Here are the results:
- Avg. Monthly Return: 1.01%
- Standard Deviation: .0324
- Sharpe Ratio: .31186
- Cumulative Return: 177.42% ($100,000 turned into $277,424.59)
In this scenario, we rebalanced at the end of each year back to a 70/30 target allocation.
- Avg. Monthly Return: .94%
- Standard Deviation: .02812
- Sharpe Ratio: .33401
- Cumulative Return: 160.81% ($100,000 turned into $260,806.98)
5% Threshold Rebalancing
In this scenario, we rebalanced whenever the actual allocation moved at least 5% away from the target allocation. This resulted in three rebalancing events during the entire nine year time frame.
- Avg. Monthly Return: .94%
- Standard Deviation: .02843
- Sharpe Ratio: .33036
- Cumulative Return: 160.64% ($100,000 turned into $260,638.42)
10% Threshold Rebalancing
In this scenario, we rebalanced whenever the actual allocation moved at least 10% away from the target allocation. This resulted in only one portfolio rebalancing event during the entire nine year time frame.
- Avg. Monthly Return: .97%
- Standard Deviation: .03002
- Sharpe Ratio: .32268
- Cumulative Return: 167.51% ($100,000 turned into $267,513.80)
Modified Schedule Rebalancing
This rebalancing technique is an annual approach, except we do nothing for the first three years in order to attempt to take advantage of the “early innings” of a bull market.
- Avg. Monthly Return: .95%
- Standard Deviation: .02827
- Sharpe Ratio: .33539
- Cumulative Return: 163.23% ($100,000 turned into $263,230.54)
Gradual Shift Rebalancing – 5% a year
This isn’t a standard portfolio rebalancing idea, but we’re still going to compare it. In this scenario, we start with a 100% equities / 0% bonds allocation with the goal of moving it towards 70/30 over time. We adjust once a year, moving the target allocation by 5% a year until we get to the 70/30 split. Then after that, we just rebalance annually back to the 70/30. So, over nine years the target allocation goes like this: 100/0, 95/5, 90/10, 85/15, 80/20, 75/25, 70/30, 70/30, 70/30.
- Avg. Monthly Return: 1.06%
- Standard Deviation: .03071
- Sharpe Ratio: .34563
- Cumulative Return: 194.54% ($100,000 turned into $294,541.94)
Gradual Shift Rebalancing – 3% a year with Fed cycle consideration
Similar to the previous gradual shift, we start with a 100% equities / 0% bonds allocation with the goal of moving it towards 70/30 over time. Instead of 5% a year, we shift 3% a year. The caveat here is that if the Federal Reserve begins a new rate cutting cycle, we immediately move to our target allocation of 70/30 (in this strategy we consider a new Fed rate cutting cycle to perhaps market the beginning of the end of the current bull market). The Fed’s new rate cutting cycle began at the end of July 2019. So we jumped to 70/30 at the end of July 2019.
- Avg. Monthly Return: 1.1%
- Standard Deviation: .03237
- Sharpe Ratio: .34101
- Cumulative Return: 206.34% ($100,000 turned into $306,339.58)
Reviewing the results
Let’s try and compare the various approaches in a couple ways.
|Strategy||Starting Balance||Ending Balance||Cumulative Return|
|Baseline (no rebalancing)||$100,000||$277,424.59||177.42%|
|5% Threshold Rebalancing||$100,000||$260,638.42||160.64%|
|10% Threshold Rebalancing||$100,000||$267,513.80||167.51%|
|Modified Schedule Rebalancing||$100,000||$263,230.54||163.23%|
|5% Gradual Shift||$100,000||$294,541.94||194.54%|
|3% Gradual Shift||$100,000||$306,339.58||206.34%|
Some takeaways when looking at cumulative return of the various approaches:
- As expected, the strategies which maintained equities exposure the most had the best cumulative return. We expected this because 2012-2020 represents a pretty steady bull market time period. As such, all traditional rebalancing approaches – either by fixed interval or threshold – underperformed the no rebalancing approach with respect to cumulative return.
- The two gradual shift strategies outperformed even the baseline approach because they started with 100% equities exposure.
But not everything is about cumulative return. It’s important to consider risk-adjusted returns. How much risk are you taking to achieve your returns? When analyzing rebalancing, looking at risk-adjusted returns probably makes more sense than cumulative return.
We’ll utilize the simple calculation of Sharpe ratio to compare risk-adjusted returns.
|Strategy||Avg. Monthly Return||Std. Dev.||Sharpe Ratio|
|Baseline (no rebalancing)||1.01%||.0324||.31186|
|5% Threshold Rebalancing||.94%||.02843||.33036|
|10% Threshold Rebalancing||.97%||.03002||.32268|
|Modified Schedule Rebalancing||.95%||.02827||.33539|
|5% Gradual Shift||1.06%||.03071||.34563|
|3% Gradual Shift||1.1%||.03237||.34101|
Interestingly, the aggressive 5% gradual shift approach led to the highest Sharpe ratio. Also worth noting is that the annual rebalancing approach had a better Sharpe Ratio than the threshold rebalancing approach. Based on this specific time period, it seems like going through the headache of following various thresholds with respect to target allocation might not be worth the hassle. Stick to the more simple annual rebalancing.
Again, a major component of portfolio rebalancing is all about what you’re comfortable with. You need to have a system in place that you’re comfortable with. Even if that means slightly lower returns over time as compared to some other strategy. Adequate returns and sound sleep. Those are the goals.