Rebalancing a portfolio amounts to market timing. In this article we use the 60/40 portfolio to demonstrate how rebalancing affects performance due to timing.
Below is a chart of annual return differences between the rebalanced and non-rebalanced versions of the 60/40 portfolio . We use SPY and TLT ETFs for the portfolio in the period 01/2003 to 12/2018.
The annual performance difference in the range -1.1% to 1.2% for all years except 2008 and 2009 when it jumps to 5% and 5.3%, respectively.
You can now guess why this happened. Let us look at the annual returns of the two ETFs below.
(1) By 2008 the non-rebalanced portfolio is already overweight SPY due to outperform relative to TLT and the bear market that follows results in 13.5% loss. The rebalanced portfolio loses less, about 8.5%, due to a good year for bonds.
(2) In 2009, the non-rebalanced portfolio is overweight bonds that have a bad year but the rebalanced portfolio benefits due to a rally in stocks.
As you can seen, rebalancing is an implicit forecast. We looked at just one particular historical path from 2003 to 2018. If events were reversed, i.e., in 2008 there was a rally in stocks and then in 2009 a rally in bonds, then the non-rebalanced portfolio could have outperformed depending on relative performance between stocks and bonds. Note the despite common perceptions, the 60/40 portfolio is a risky investment.
Going forward, relative outperformance will depend on relative returns. There are some possible scenarios, including one with both stocks and bonds dropping. Rebalancing or even changing the allocation is maybe more appropriate in the context of a timing model that turns implicit timing to explicit and maybe more honest too.
To conclude all transactions in markets, including rebalancing of portfolios, amount to forecasts. Anyone who claims a bond/stock portfolio that is annually rebalanced is not market timing does not maybe understand these simple facts.
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