The Concept of Rebalancing: Its Essence and Application - GERCHIK & CO

The concept of rebalancing, Its essence and application

05-11-2019
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Today, we are going to talk about investment portfolio rebalancing and its advantages.

You will learn:

1. What rebalancing is and what it is meant for
2. Advantages of rebalancing and its role in keeping the capital safe
3. Mixing rebalancing technique with other approaches

Aside from a regular purchase of stock for the investment portfolio for the purpose of holding them long term, there is another way to form a portfolio, and it is to apply the rebalancing technique.

Essentially, it consists in locking in profits for one set of assets, while simultaneously managing the risks. Without leaving the market, one extends the portfolio with uncorrelated assets instruments, thus restoring the previous balance.

The Concept of Rebalancing

What rebalancing is and what it is meant for 

Let’s consider the example of money market instruments. For better understanding, let's use bank deposit and a highly diversified portfolio for S&P 500 index.

According to a rule of thumb, individuals should hold a percentage of stocks equal to their age.

The idea is that in case of a stock drawdown, you have got a reserve time: the younger you are, the greater the chance of witnessing a new growth cycle.

Let’s consider what would have happened in practical terms, had we picked the wrong time for buying a portfolio in 2007. Let’s take S&P 500 index to serve as the highly-diversified portfolio of securities with 2.01% annual dividend yield.

We are going to take 50% of stock and 50% of the money market instruments for allocation. The purpose of rebalancing is to make a reverse rebalancing and return to the previous 50/50 ratio according to either temporary criteria like in this case or other criteria.

It goes without saying that if stock price goes up or down, the ratio changes. In this case, the rebalancing implies bringing the portfolio to the same ratio.

The greater the share of stocks in the portfolio, the riskier it is. You have to factor this in when changing 50/50 ratio.

It is worth recalling that the essence of bonds is a return at face value, and their percentage is our rate of return. The bank deposit is a hedge against inflation with a small bonus for giving away the money for now. When it comes to stocks, we will get them at the current quoted price.

Now, let’s take a closer look at the data shown in the table to see what this type of capital allocation would leave us with. If we had fully invested in the stock market or SPX500 share portfolio during the financial crisis of 2008, the maximum drawdown would have totaled -57.40%, i.e. more than a half of our savings.

The essence of it lies in the conservative capital allocation and protection against this drawdown. As a result, we get the maximum drawdown of -25.40% for the portfolio (SPX500 and bank deposit).

Advantages of rebalancing and its role in keeping the capital safe 

Rebalancing maintains a single ratio between stocks and money market instruments.

In case of the stock drawdown, the allocation allows restoring the value of the portfolio at the reverse in the securities, since it is known that the prices of all stock cannot drop down to zero.

Rebalancing: skrin1

Everything seems to be going great. We manage the risks, and our financial performance exceeds bank interest rates.

By mixing a simple buy and hold strategy with a conservative asset allocation and rebalancing, we get more protected against a large drawdown.

This is practical method is intended for long-term holding - not for 1-2 years, but for 5, 10, 15 and more. What’s so great about it is that the income exceeds the bank interest rate by limited risks.

However, let's imagine that this is not 2008, but, say, 1929. Following the drawdown, the index got stuck for a long 25 years.

Assume the situation repeats itself, i.e. during the period from 1929 to 1954, we have got 25 years. The high of 2007 is 157.52, and the low is 67.10. Suppose there is a restoration for 25-year period. Then we divide the difference of 90.42 pips by 25 and get an average of 3.62 pip of restoration per annum.

Rebalancing: skrin2

Based on data shown in the table above, we can see that we would have completely restored the portfolio value by 2013, even in case of stagnation. Now, by getting 5.86%, we would have already exceeded - albeit insignificantly - the bank interest.

As a result, the wave of intense growth would be restored n 15-20 years, and we would be majorly ahead of the bank rate. However, the question is: will the rate stay at 4.5% during such time periods? Whatever the case, we have still preserved the capital.

As mentioned previously, this is a more conservative approach to the buy and hold strategy which allows surviving possible strong index deviations and drawing ahead of the bank rate.

In practical terms, the formation of investment capital is based on a percentage of deductions from our income, which means that capital will be time-spaced and allocated at different price values of the stock index, including the highs and lows i.e. there will be some average value.

Even despite the critical drops in the long run, price values tend to increase due to inflation.

Mixing rebalancing technique with other approaches

Are there any other options, apart from this approach? Absolutely!

  1. First of all, it is just one of the many techniques that proves the importance of knowing the finances and capital allocation tools.
  2. Second of all, this approach can be used for investment and speculation: having a sufficient degree of professionalism, you can speculate more on the highs and opt for the investment approach on the lows.
  3. Third of all, by not investing the entire amount all at once, but laying the funds aside on a monthly basis, we will get into the index drawdown period only partially, since the savings will be time-spaced.
  4. Fourth of all, technical prerequisites also matter, but it requires experience and knowledge.
  5. Fifth of all, by rebalancing the capital, you can invest in managers the same way.

In a nutshell, there are many options to choose from, and each investor can find the one that suits his or her needs best depending on the attitude toward risk, desired profitability, and degree of trust in different methods.

Some choose to allocate three portions; some decide to continue studying finance towards active capital management. Everyone has their own way.

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