The Case For and Against Rebalancing Your Index Portfolio

Case For Rebalancing

Owning a well balanced index portfolio is a strategy to reduce volatility within your investments. Over time, some indexes will over-perform while some will underperform. In order to maintain a high level of protection against market volatility, it is good practice to rebalance your portfolio at least once a year. When rebalancing, you are looking to lower risk exposure, but not maximize long-term returns. Meaning the volatility of your investments will be lowered but so will your average expected long-term returns. Vangaurd has compared how two hypothetical portfolios (50% global bonds, 50% global stocks) would have differentiated from 1929 to 2014 with or without rebalancing. Regarding the benefit of balancing, the annualized volatility was dropped from 13.2% to 9.9%. This is because stocks have historically had higher returns than bonds, thus over a larger sample size the portfolio becomes progressively more stock-heavy and therefore more volatile.

One benefit of rebalancing is being honest about the time horizon of your investments. Any given year when the stock market experiences a loss, the investor with a greater bond exposure will do better. Bond indexes tend to provide an almost linear return. Here is how the Canadian Bond index has grown (with reinvested interest) since inception in 2000. 

TDB909  Canadian Bond Index Performance Since Inception

Source: TD Canada Trust

Clearly having a greater exposure to this index in your portfolio will offer risk protection versus more more volatile stock index. You expected returns on the flip side will be capped lower. This index has actually increased in value in 9 of the past 10 years, with returns ranging from -1.6% (2013) to +9.1% (2011). (fund fact page)

If we compare it to how the Canadian stock Index has done since inception in 1999 (with the use of DRIP).

TDB900  Canadian Stock Index Performance Since Inception

Source: TD Canada Trust

While still exhibiting an upward trend, the road is more bumpy here. In the past 10 years this index has increased in value 8 of 10 years, with returns ranging from -32.9% (2008) to +34.6% (2009). (fund fact page) 

Note that when assessing historical prices, these represent indications of volatility, risks and historical trends, but do not present future predictions on returns. 

Another benefit of indexing is that it forces you to stay up to date with your investments. If at least once a year, you analyze your portfolio and add money to it, you are being a proactive investor! This in itself is very valuable. Another benefit of rebalancing is that it forces you to add money to investments that have had mediocre results, not to the winning funds. This way you are not engaging in any sort of performance chasing (i.e. putting your all your contributions in the index that has had the best returns last year).

Case For Not Rebalancing

You could also make a strong case for not balancing. Since balancing is a strategy to reduce variance, not maximize returns, you may decide it's not worth it. You just have to be ready to accept that your portfolio will be more exposed to market fluctuations. Going back to the Vangaurd comparison, the annualized return of the balanced portfolio was 8.1%, while that of the unbalanced one was 8.9% (over the 85-year assessment). While this is a hypothetical scenario, it does indicate a notable difference in returns. If you do not value rebalancing, then you could also simply omit investing in bond indexes altogether, as this will further increase your chance of obtaining maximum returns. This comes down to a personal question of how comfortable you feel with handling risks within your investment portfolio. Personally, I find that having some small bond allocation is a good idea. If global markets drop and you have no additional money available to invest but hold 15-20% of your portfolio in bonds, you can sell some to purchase cheaper stock indexes. This enables you to remain more versatile with your investments and gives you more flexibility to react to external market dynamics.  

Another potential argument for not investing in bond index is that they represent a higher MER than both North American stock index options. Therefore by investing in stock indexes, you are paying less to own an investment with greater potential returns (not the case for the international stock index). 

Whether or not to use rebalancing will be a personal decision, although it is considered to be good practice. If you have any questions about rebalancing, comment below!

-Yinvestors.

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