While it may seem counter intuitive to add higher-risk securities to a portfolio during times of severe market stress, doing so can be part of a prudent rebalancing strategy, according to a paper from T. Rowe Price Inc.
“Regularly reorienting to targeted long-term asset allocations helps ensure that all risk exposures in the portfolio are intentionally accepted,” the paper said. “However, many investors may be reluctant to follow their normal rebalancing policies in periods of market stress, when adding to higher-risk exposures may seem particularly unpalatable.”
The paper examined rebalancing methods through both historical and simulated market drawdowns using various rebalancing rules. Notably, it found no silver bullet rebalancing rule exists. Indeed, some rebalancing rules work better in certain simulated market stress scenarios than others. “We believe investors should select the rebalancing approach that they believe is most appropriate for them, given their own circumstances, and adhere to it through all periods, especially during market drawdowns and recoveries.”
Using any of the rules outlined in the paper would have caused a portfolio to outperform a hypothetical, non-rebalanced portfolio (60 per cent in global equities and 40 per cent to U.S. bonds) over any 10-year period since 1989, suggesting that using a rebalancing policy improves portfolio performance over full market cycles.
“Despite the potential benefits of adhering to clear portfolio rebalancing rules, investors may be tempted to abandon their rebalancing policies during market drawdowns to avoiding buying into falling markets,” the paper said.
To examine the potential pitfalls of abandoning rebalancing policies, the paper used four rebalancing rules: one monthly, one quarterly, one based on maintaining relative exposures within a plus/minus 2.5 per cent band and another for a band of five per cent. The average margin of cumulative excess returns, based on the historical 10-year rolling periods covered in the study would have ranged from 4.22 percentage points for the monthly rule, to 6.07 percentage points for the plus/minus five per cent rule.
Looking at historical scenarios also demonstrated rebalancing rules to be beneficial. Indeed, all four rules showed outperformance for hypothetical portfolios during the technology bubble of the late 1990s and the 2007 to 2009 global financial crisis. However, not all four rules produced the same level of benefit, the paper found. “We found considerable dispersion across the rebalancing methods in terms of both the value added and the frequency of outperformance. Moreover, while historical scenarios can be insightful, future market sell-offs and recoveries are likely to follow different paths.”
While investors may not know what form the next downturn will take, rebalancing rules can potentially help. “Rebalancing portfolios in accordance with a set policy helps align allocations with investor expectations and potentially helps minimize unintended risk. Our results show that disciplined adherence to a balancing policy, both over the long term and through periods of market stress, potentially can lead to a meaningful improvement in portfolio performance. While we recognize that buying assets that are falling in value can be a difficult decision, we believe that investors should not abandon their normal rebalancing policies, especially during market sell-offs.”