Getting the balance right


Flying in turbulent times – aeroplane pilots train extensively for emergencies - if they do encounter an unexpected situation their actions, are essentially automated. This is so their emotions do not get in the way of decision making. When things do go wrong it is often because protocols were not followed, ie human error. Likewise, surgeons follow checklists to reduce medical errors. Would you feel safe flying with a pilot who had only prepared for good times? Would you be comfortable going for surgery if the doctor had to make all decisions on the spot without guidelines to help them? I wouldn’t!

However, it is interesting that investors do not go through market crisis training, they may perform stress tests on the portfolio, but they do not go through simulations for how they would act if an event occurred or follow a checklist when making investment decisions. This can also be a life-changing situation. Rebalancing is an often-overlooked part of investing, that can make a crucial difference to investment returns.

Investors are typically not rational at the best of times, but it’s difficult (though cheaper) to buy more of an asset when the price is falling. It’s also hard to sell an asset when it’s appreciated – but what if it goes up more? Reducing human biases and emotions by pre agreeing what you will do is extremely helpful. It’s likely you have spent a lot of time determining investment strategy – rebalancing ensures that you remain on track and do not go on a different course than you initially had in mind. Not having a strategy in place is like being unprepared for a difficult event. Rebalancing is particularly important in turbulent times – bear markets.

After the 2008 crisis the Norway pension fund (known for being well managed) rebalanced, Calpers did not. This meant Calpers missed out on the subsequent bull market – which led to substantial differences in their funding levels.

Rebalancing also applies within asset classes, for example, an equity manager needs to consider rebalancing to their target sector allocation, or the portfolio could become unbalanced.

Types of rebalancing strategies

Time based strategies

A time-based strategy is mechanical and would rebalance the portfolio to the strategic asset allocation at set time intervals, for example, monthly or quarterly. This strategy does not consider market data or pricing at the time the portfolio is being rebalanced so trading conditions may not be ideal. The investor should decide which asset classes to include, illiquid assets are typically excluded due to high transaction costs. The benefit of this type of rebalancing strategy is that it requires less monitoring.

Constant mix/threshold strategies

Another approach is to give target weightings to each asset class in the portfolio and rebalance when the asset classes deviate away from their strategic asset allocation by a certain percentage, eg 5% outside of target allocation. The range for each asset class will vary based on its characteristics. Assets with higher transaction costs should have wider ranges to reduce transaction costs. Asset classes with high volatility should have a narrower range as they can easily move away from the target and have too high or too low a weighting in the portfolio.

This strategy requires closer monitoring as asset class weights move, to determine when to rebalance.

Combining the two

This would mean monitoring the portfolio at set intervals and rebalancing if the allocation is outside of the ranges at that time.

Rebalancing when markets are unpredictable or choppy

Markets are always unpredictable but sometimes it may be particularly difficult to decide whether to rebalance – as was the case over the last few months. In this case partial rebalancing ie rebalancing 25% or 50% to target may be a good solution. If markets are already rebounding as you are rebalancing, you will benefit from the rebound but not be overexposed to the asset class. If markets continue on a downward trend, you have another chance to rebalance at a lower price and will be better off than if you had rebalanced fully. And if markets don’t move, you can rebalance further and are not better or worse off.

Turning water into wine

Diversification is known as an investor free lunch, is there another? The main purpose of rebalancing is to reduce risk (by ensuring a single asset class is not over or underrepresented in the portfolio and of course by taking out human biases) however research has found that it also enhances returns – how? The long-term effect of mean reversion (or capitalising on volatility aka volatility harvesting). By selling an asset after significant outperformance or investing in an asset after underperformance, the reversion to the asset’s mean price will generate returns.

UK equities and UK fixed gilts

Source: LCP chart created using data from Bloomberg, over 20 years to 30 June 2020

The chart shows a portfolio of UK equities (FTSE All Share) and UK gilts over 15 years with different mixes. Looking at the annualised returns on the portfolios after 20 years, the portfolio with annual rebalancing (yellow line) outperforms the portfolio that was not rebalanced (grey line).


It is important to understand that having a rebalancing policy in place or indeed doing nothing by not rebalancing is an active investment decision and one that could play a key role in investment outcomes. So, have you prepared for a smooth landing?

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