Rebalancing: Canadian Edition

Executive Summary

  • Portfolios need to be periodically rebalanced to ensure they maintain asset allocations dictated by the investor.
  • These rebalancings have the added benefits of often increasing total return.
  • Most importantly, regular rebalancing results in a reduction of portfolio volatility.

According to Modern Portfolio Theory (MPT) – a concept pioneered by Harry Markowitz – investors can construct portfolios to optimize maximum expected return for a given level of risk by combining various securities (or asset classes) which have varying degrees of correlation and expected return.

MPT is a large reason why standard portfolio recommendations center around a mix of 60% equities and 40% bonds.

Most investors intuitively understand the benefits of diversification from such a portfolio. It doesn’t take much for them to realize that the volatility will be lower and the outcomes better for the same degree of risk.

Yet how many of those investors allocate based on that model and then fail to recognize that the changes in the market prices of those securities can dramatically alter the portfolio’s composition?

Imagine an investor who chooses the typical 60/40 equity/bond split. Then over the next year stocks rise 10% while bonds decline 1%. Instead of having exposure to the original asset mix, the investor actually has 62.6% equities and 37.4% in bonds. It doesn’t take many years for an un-managed portfolio to drift significantly from the original asset allocation.

Although portfolio management takes patience, neglect is no prescription for success. Systematic rebalancing of portfolios back to an investor’s desired level of risk is an obvious course of action from the perspective of maintaining the proper point along the MPT efficient frontier, but empirical evidence suggests that rebalancing has the added benefit of lowering overall portfolio volatility without giving up any total return, and in fact, often achieving a higher return.

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