The Rebalancing Bonus

Smart investors diversify their investments across different asset classes (stocks, bonds, etc.). They determine fixed target weights for each asset class. This is called asset allocation. As different asset classes either outperform or underperform the others, the weights drift from their target weights. Rebalancing is the process of using purchases and sales to bring your portfolio back to the target weights.

So...you choose an asset allocation for your portfolio and you rebalance the portfolio on a periodic basis to maintain that asset allocation. Sounds pretty straightforward, right? Yes, it is. And rebalancing is important enough just to maintain the desired asset allocation and the associated risk/reward profile for that mix of assets. But rebalancing also provides an unexpected bonus!

I like bonuses, tell me more

Let's first look at an example. Here are the inflation-adjusted returns of US stocks and T-bills from 1970 - 2021.

Stocks had a compound annual growth rate (CAGR) of 6.7% and T-bills had a CAGR of 0.9%. If you owned a regularly rebalanced portfolio with 50% of each, what would the return be? Most people would expect 3.8% (the average of the two numbers).

But the actual CAGR was 4.2%. That's a difference of 0.4% per year (or 11%). Witchcraft!

It's actually explained by a mathematical concept demonstrated by a man named Claude Shannon back in the 1940's. It's known as Shannon's Demon.

The rebalancing bonus is most prominent when:

The overall returns of each asset are similar.
Each asset is highly volatile and negatively correlated.

Let's look at one more example.

From the 40-year period beginning in 1970, stocks had a CAGR of 4.9% and gold had a CAGR of 4.0%. Want to guess the return for the regularly rebalanced portfolio of 50% of each?

Regularly rebalancing between stocks and gold generated a return of 5.8%, nearly a 1% annual premium over investing in the highest returning individual asset!

How often should you rebalance?

Vanguard conducted a detailed study on this topic. The short answer is that annual rebalancing is usually best. People sometimes devise more complicated methods for rebalancing, but there's no need. Keep it simple. Pick a date and do it every year on that date.

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Key Takeaways

The rebalancing bonus is not guaranteed to generate “free money” above and beyond any one investment. Sometimes it will, and sometimes it won’t. But even when it doesn’t, it can still improve the risk-adjusted returns of the portfolio.

The benefits of rebalancing are most strongly seen in portfolios with volatile uncorrelated assets with similar returns.
There's no benefit to rebalancing more than once a year.

I didn't get into all the math behind Shannon's Demon. You can dive deeper using the additional sources below.

Unexpected Returns: Shannon’s Demon & the Rebalancing Bonus

Shannon’s Demon & How Returns Can Be Created Out Of Thin Air

How Portfolio Rebalancing Usually Reduces Long-Term Returns (But Is Good Risk Management Anyway)

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