1. Portfolio
Perspectives
January 2013
Get A “Free Snack” from Portfolio Rebalancing
and economic environments and generates dissimilar returns. While
dissimilar returns provide the benefit of diversification, they can
By Joni Clark, CFA, CFP® also cause the asset allocation of the portfolio to “drift” away
Chief Investment Officer, Loring Ward from its target. And since riskier asset classes are generally
expected to earn greater returns over time, they will gradually
assume a greater weight in the portfolio, thus increasing the risk
Economists are famous for pronouncing gloomily that “there’s no of the overall portfolio.
such thing as a free lunch.” Yet finance theory does offer a free lunch: Without rebalancing, your original 50/50 investment portfolio
the reduction in risk that is obtainable through diversification. An over time can turn into a 70% stocks and 30% bonds mix.
investor who spreads her wealth among many investments can We’ve all heard the investing adage that we should “buy low, sell
reduce the volatility of her portfolio, provided only that the underlying high.” This is exactly what rebalancing attempts to accomplish,
investments are imperfectly correlated. There need be no reduction by taking money from assets that have performed well and rein-
vesting in assets that haven’t. Rebalancing systematically trims
in average return and thus no bill for the lunch.
the highest-returning asset classes, restoring the portfolio to its
— John Y. Campbell, Diversification: A Bigger Free Lunch target allocation.
If diversification has the potential to improve the risk and And better yet, it is historically shown that you are also likely to
return of a portfolio (a supposed “free lunch” to investors) then see better returns over time by rebalancing a portfolio.
perhaps the recent track record of rebalancing for improving According to research by Fernholz & Shay (1982), you are likely
returns and reducing risk may seem like a “free snack.” to see better performance over time by rebalancing a portfolio
Diversification is a valuable tool for managing risk in a portfolio. A because managing portfolio volatility should have a positive
portfolio that holds assets that do not perform similarly should impact on long-term portfolio growth.1 Of course, past perfor-
experience less overall volatility over time. But maintaining the mance is no guarantee of future results.
proper allocation of your portfolio through rebalancing is also Rebalancing does not increase portfolio returns over every time
an important step to manage risk. period because the returns are highly dependent on the prevailing
If you and your advisor determine that a basic portfolio made market environment and cycles during the investment time
up of 50% stocks and 50% bonds is right for you, then you’ll period measured.
want to keep it that way, and that’s where rebalancing comes in. But the good news is that rebalancing did provide many investors
Each of the asset classes in your portfolio reacts differently to market with a “free snack” during the turbulent market environment
Robert Fernholz and Brian Shay, Stochastic Portfolio Theory and Stock Market Equilibrium, Journal of Finance (May 1982).
1

2. Portfolio Perspectives
surrounding the financial crisis and the debt crisis that followed annualized basis; however, the rebalanced portfolio enjoyed much
— a time when investors could really use a little extra return lower volatility with a standard deviation of 7.51 as compared to
from their portfolios. 9.09 for a portfolio which was not rebalanced.
For the five-year period from December 2007 through November The five-year period was selected in this analysis to represent
2012, a portfolio with 50% in stocks and 50% in bonds that was the financial and debt crisis period which we believe is notable
rebalanced annually to its target allocation would have earned an because it was a particularly trying and emotional time for
almost 1.5% greater annualized return than the same portfolio investors. Many investors would have been reluctant to sell
that was not rebalanced at all during the five-year period. bonds and buy stocks during this period.
This equates to 8.6% more cumulative growth over the five-year Unfortunately, rebalancing may seem counter-productive to
period. And the best part is that the rebalanced portfolio delivered some investors. Why sell a portion of a high performing asset to
greater returns with lower overall volatility (standard deviation acquire a larger share of a low performing asset? Intuition might
measures volatility, so the lower the number, the better it is for suggest that selling previous winners may hinder returns in the
your portfolio). future. As the chart below illustrates, when the stock market is
going up, emotionally we tend to believe it will continue to go
Rebalanced vs. Drifting Portfolio
Five-Year Performance Comparison up and we’re driven by the desire to buy. When it goes down,
December 2007 – November 2012 we’re afraid it will continue to decline, and our fear may make
Annualized Cumulative Standard
us want to sell.
Return Returns Deviation Cycle of Market Emotions
Rebalanced
Portfolio
4.68% 25.28% 6.94%
Drifting Portfolio 3.20% 17.07% 7.49%
Rebalancing
Benefit
1.48% 8.61% -0.55%
Source: Dimensional Returns 2.0 (December 2012) Portfolio consists of 50%
stocks as represented by the S&P 500 Index and 50% bonds as represented
by Five-Year Treasury Notes. The Rebalanced Portfolio is rebalanced back to
target weights on an annual basis on January 1, whereas the Drifting Portfolio is
not rebalanced for the entire investment period. The inception date of the portfolio For illustration purposes only.
is January 2003, and the standard deviation is measured from this date. Past
performance is no guarantee of future results. This is for illustrative purposes only
and not indicative of any investment. An investment cannot be made directly in an In the end, it’s not peaks and valleys that really matter, but the
index. Performance shown includes reinvestment of dividends and other earnings growth of wealth over an investor’s time horizon. The odds are
but does not reflect the deduction of advisory fees, transaction costs or the taxes that you’ll see better performance over time by rebalancing a
associated with trading the portfolios. The buying and selling of securities for the
purpose of rebalancing may have adverse tax consequences.
portfolio than you would by leaving the portfolio unattended.
Again, rebalancing does not guarantee greater returns over every So remember, once you have established an investment portfolio
period, and often the return enhancement will be lower over that suits your unique financial situation and risk tolerance,
longer periods measured. For example, if we examine the 20-year rebalancing helps to ensure that your portfolio stays on track
period beginning January 1993 through November of 2012, the with your risk profile and stays true to your long-term plan for
return enhancement for a rebalanced portfolio was only 0.4% on an achieving your financial goals.
Past performance does not guarantee future results and the principal value of an investment will fluctuate so that an investor’s shares, when redeemed,
may be worth more or less than their original cost. Stock investing involves risks, including increased volatility (up and down movement in the value of
your assets) and loss of principal. Implementing a short-term fixed income investment strategy or rebalancing cannot guarantee a profit or protect against
a loss. The buying and selling of securities for the purpose of rebalancing may have adverse tax consequences.
© 2012 LWI Financial Inc. All rights reserved.LWI Financial Inc. (“Loring Ward”) is an investment adviser registered with the Securities and Exchange
Commission. Securities transactions may be offered through Loring Ward Securities Inc., an affiliate, member FINRA/SIPC. B 12-071 (Exp. 12/14)