Rebalancing Your Stock Portfolio? Luck Matters.

If you’re like a majority of investors, you probably hold more than one security in your portfolio. Maybe you equal-weight a basket of 30 high-quality stocks. Perhaps you’re nearing retirement and are considering the classic 60/40 portfolio — one that allocates 60% to a broad-market equity index fund, like State Street’s S&P 500 ETF Trust (NYSEMKT: SPY), and 40% to a total bond fund, like Vanguard’s (NASDAQ: BND).

Regardless of what you hold, you likely have a target allocation in mind that you want to maintain. To do that, you rebalance your portfolio at fixed intervals — selling outperforming investments and buying underperforming ones every month, quarter, or year — so that your investments are reset to their original allocations.

You might be left wondering, however, if your systematic approach to rebalancing is enough to curtail the effects of luck on your portfolio’s performance. Does it matter when you rebalance? And if so, what can you do about it? Let’s dig deeper.

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What is rebalance timing luck, and why does it matter?

To spare you the suspense, when you rebalance does affect portfolio returns — and this is true even if you rebalance at regular periods. To illustrate this point, consider two portfolios, A and B. Each holds the same securities at identical target allocations — 50% SPY and 50% cash. The portfolios are rebalanced annually — A is rebalanced every January, and B is rebalanced in June. In other words, these two portfolios are the same — save only for when they are rebalanced.

Even so, A and B will perform differently, solely because they are rebalanced in different months. How the market performs in the interval between these two portfolios’ rebalancing dates, when one portfolio temporarily has a higher allocation to SPY than the other, will lead A to outperform B (or vice-versa).

This is the essence of what Faber (2013) and Hoffstein (2015) call rebalance timing luck, and it universally afflicts all rebalancing strategies. Whether you’re rebalancing 30 hand-picked names back to equal weight or between stocks and bonds in a 60/40 portfolio, rebalance timing luck will impact your portfolio’s return profile.

And this is no trivial matter. The effect of timing luck on a portfolio of 100 stocks rebalanced twice a year can amount from one to four percentage points annually, but this is just for starters. Timing luck can permanently impact terminal wealth to the tune of thousands or even millions of dollars, depending on your initial portfolio value and time horizon.

What can you do about it?

Luckily, there are several things you can do to minimize the impact of timing luck. Specifically, you can:

Rebalance more frequently. The effects of timing luck decrease as you rebalance more often, because markets are less likely to experience significant changes over shorter periods of time. A portfolio rebalanced daily will experience less timing luck than one rebalanced annually.
Hold more investments. A well-diversified portfolio of 1,000 stocks will exhibit less rebalance timing luck than a concentrated basket of just ten stocks.
Reduce portfolio volatility. Less-volatile investments, like a collection of investment-grade bonds, are less affected by timing luck than more volatile ones, such as a portfolio of leveraged ETFs.

However, none of these fixes come without drawbacks. Frequent rebalancing increases transaction costs, which drag down performance — a more diversified portfolio also suffers from the same problem. And opting for less-volatile investments won’t solve this problem either, since you sacrifice the higher potential return you could earn with more volatile strategies.

In short, each of these luck-mitigating strategies will cost you something, and you should carefully determine if they are worth your while.

The takeaway

Rebalance timing luck affects every rebalancing strategy and nearly every portfolio. As a systematic investor, you want to insulate your portfolio from unwelcome changes in fortune — but a routine, regularly scheduled rebalancing strategy, though an integral component of a prudent investment strategy, is not alone enough to “luck-proof” your portfolio. Nonetheless, diligent investors who engage in thoughtful analysis with the help of their newfound knowledge on rebalance timing luck are more likely than not to come out ahead.

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