Portfolios provide middle-of-the-road performance when compared to its constituent positions but at a much lower volatility. Rebalancing is aimed at improving the performance while reducing volatility even further.
We compared the performance of stocks, bonds, commodities and real estate in our blog “Asset Classes 30-Year Performance History.” Here we will use these asset classes to build a portfolio and show its benefits. The chart shows the growth of $1 invested in these 4 asset classes. As explained in the aforementioned blog, stocks performed the best, followed by bonds, gold price and US median home price. However, stocks were also the most volatile and bonds the least. The effects of leverage and rent potentials were not part of the analysis. A portfolio with equal weights in each of these 4 asset classes would have resulted in the middle-of-the-road performance and corresponding volatility when compared to individual asset classes.
The first step in constructing a portfolio involves selecting the asset classes. The next step is to determine their respective asset allocation percentages. If rebalancing is going to be part of the strategy, then the asset levels are to be brought back to their original allocation (% of portfolio) either based on a time period or a performance threshold, often in combination with macroeconomic conditions. For example, rebalancing can be done annually or whenever an asset class reaches a certain growth target, either individually or relative to the portfolio. The macroeconomic situation for bonds is not great for the foreseeable future because interest rates can only go up from today’s near zero rate. If rebalancing is not part of the strategy, then the individual asset classes are allowed to grow independent of each other.
Rebalancing is targeted toward taking advantage of the boom/bust cycles which asset classes go through, by selling appreciated assets thereby locking in the gains, while buying depressed assets on the cheap. Please read “Cyclic Nature of Asset Classes” for more details. In our example portfolio, annual rebalancing only marginally improved the performance, but it helped lower the volatility from 7.4% (no rebalancing) to 6.1% (with rebalancing). Our blog “Efficient Frontier and Diversification” provides a detailed view of how portfolios help diversify and reduce risk.
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