The Amazing Rebalancing Premium

Jason Zweig has an excellent article in the WSJ about advisors who go along with clients's desires to increase allocations to the most recently outperforming asset classes.

He writes:

Investment professionals are supposed to exercise independent judgment; in Warren Buffett's words, they should be fearful when others are greedy and be greedy only when others are fearful.

Financial advisers contend that one of their most important functions is encouraging clients to "rebalance," or sell whatever has gone up and buy whatever has gone down.
The TD Ameritrade and Schwab numbers suggest, however, that financial advisers have been unbalancing instead of rebalancing their clients' accounts. By selling stocks as they fell and buying bonds as they rose, advisers may have ended up exposing clients to more risk, rather than less

That's a shame of course because imo one of the key reasons to use an advisor is to prevent the tendency of investors to fall into all the investing pitfalls well documented in the behavioral finance literature. My rule of thumb in my practice is to tell the client falling into one of these pitfalls "you're paying me to talk you out of doing this". I do this on the first 2 calls on the third call I tell the client "it's your money and I'll follow your instructions even though I think you are making a mistake". After that I try, not always successfully, to avoid any "I told you so " discussions. In my view the only reason to make a major change in allocation is a change in the clients personal circumstances although I might include the client's recognition that his risk tolerance (which really means his tolerance for loss) is not really what he thought it was.

Rebalancing make intuitive sense after all one is selling high priced asset classes and selling low priced ones. Contrary to how it may feel asset classes that have appreciated greatly are actually more risky than those that have suffered sharp declines. But the most interesting thing about rebalancing is that it is a "free lunch" it increases returns while reducing risk .Of course classic finance tells us that this is impossible but the numbers don't lie ?

Consider this portfolio from Sept 2000 to Sept. 2010 (the" lost decade" for stock investors US stocks returned nothing over the period):

35% total bond index
40% US total stock market
12.5% Developed International
12.5% Emerging International

Investor A rebalances each year selling out performers and buying underperformers to get back to his target allocation, His initial $100,000 invesmtent would have grown to $166,000

Investor B did not touch his portfolio letting his holdings in the outperformers grow. His portfolio grew to $150,000

But that is only part of the argument for the rebalancing. The annual standard deviation for investor A was 11.37 vs 14.1 for the non rebalancer  rebalancing reduced risk. Here's another way of looking at risk that may actually be more striking for the non finance geek.

for the non rebalancer the worst 12 month period was a loss of  38.8% for the rebalancer : -30.3.

So if you are investing on your own work you hardest to fight the trend and rebalance. And if your advisor is as Zweig puts it:..

instead of holding your hand, some advisers might prefer to pull you by the hand in the direction you are already headed.

You and your advisor may be in a dysfunctional relationship .

a good article on rebalancing from Financial Advisor Magazine it includes this chart on the rebalancing premium for a simple 60/40 stock bond mix