Source: Capital Spectator



The most perplexing thing I read this week was an odd column by Paul Merriman at MarketWatch, “Why Rebalancing Could Be a Huge Mistake.” He makes the counterintuitive claim that portfolio rebalancing doesn’t really work: “Conventional wisdom holds that regular rebalancing is a sound practice to control investing risk. But I’ve concluded that some of that conventional wisdom is wrong.”

I dismissed Merriman’s claim offhand because what he described was not true asset class rebalancing. He was looking within the same asset class — U.S. equities — and subdividing them into four market cap weighted, style-based subgroups: large-cap, small-cap, large-cap value and small-cap value stocks.

His conclusion that rebalancing among these four didn’t work was a bit disingenuous. If you went on an all-Chicago-deep-dish-pizza diet and didn’t lose any weight, you wouldn’t exactly be justified in declaring that diets don’t work. But that is functionally the equivalent of Merriman’s critique of intra-U.S.equity rebalance.

But rather than rely on my own insights into rebalancing, I tracked down two experts who have studied rebalancing for years. Their criticism was much stronger than my own.

Robert Arnott runs Research Affiliates, where he helped craft the idea of fundamental (as opposed to market cap weighted) indices. RAFI, as the firm is known, generates returns through a combination of smart beta and asset allocation strategies.

Arnott critiques Merriman’s rebalancing claim as a “flimsy and meaningless straw man.” He shows through a series of examples what occurs if you chose not to rebalance a portfolio: The investor loses the benefits of diversification, as the portfolio over time morphs into a riskier, 99 percent stocks, mostly small-cap value fund.

The obvious risk (at least to me) with such a portfolio drift is the behavior of its holders. Any un-rebalanced portfolio eventually would become a gnarly mass of volatility and drawdowns. Imagine what that does to the psyche of the investor saving for retirement. It invites bad behavior and poor decision-making. Meanwhile, a diversified portfolio will have different sectors doing better or worse each year, producing more stable returns.

James Picerno takes a different critical approach to reach a somewhat similar conclusion. He starts with the caveat that the “optimal rebalancing strategy” is unknown in advance. Instead, it is designed specifically because we never know what the future holds. Rebalancing what is essentially an all equity portfolio of using only U.S. equities is not the same as rebalancing a broad asset allocation model. We should not expect “an equities-only portfolio” to have the same results via rebalancing than what we can achieve via a regularly rebalanced multi-asset-class strategy

We may not know in advance the precise improvements rebalancing produces over time, but we do know they are substantial. The alternative is a massive drift from one’s original asset weighting.

Any asset allocator who is comfortable with what will eventually become all equity portfolio should skip rebalancing. The rest of us continue to take advantage of what may be the only free lunch on Wall Street.


Category: Asset Allocation, Investing

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

4 Responses to “Worst Allocation Advice of the Week”

  1. VennData says:

    More lies from the “We need Wall Street advertising” people.

    Thank you BP.

  2. bigsteve says:

    Took me a long time to change my view that holding an all stock portfolio was best because long term stocks out preform other assets. By having your assets in different classes at preset percents that are not correlated much variability becomes your friend as you can sell high and buy low which will enhance your long term profit. Seems counter intuitive but this works.

  3. rd says:

    I think people are misreading Merriman’s article. My reading of his article is that he argues that the portfolio should still be rebalanced between stocks and bonds, but the equity component should not be rebalanced within itself.

    From the article:

    “So here’s my advice, in three parts. First, all investors should continue to rebalance between stocks and bonds. This is a legitimate tactic for controlling risk. Second, young investors probably will do better over the long haul if they don’t rebalance among equity asset classes…. Third, older investors, certainly including retirees, should be more conservative and not let any single asset class get too far away from its target percentage….”

    As a result, a 60/40 portfolio will still be a 60/40 portfolio (it won’t morph into a 99% stock portfolio) but the equity component could be significantly overweight small value or EM or whatever the long-term hot sector was for the previous 30 years. It is one step beyond the concept of not rebalancing until portfolio components have deviated by more than 5% instead of rebalancing to the penny every year or quarter.

    He uses backtesting over the past few decades to demonstrate it would have done better. Who knows what the next 30 years would bring.

    I haven’t done the backtesting to have an opinion. I just think that people should be arguing about what he wrote, not what he didn’t write.

  4. mpappa says:

    Data demonstrates annual rebalancing is best. The financial media is sector focused and has a short term time horizon. Always keep that in mind.