Rebalancing an investment portfolio increases long-term returns while reducing risk. It’s sometimes called Investing’s Free Lunch. You get something positive in return for doing almost nothing. Recently a study was published disagreeing with that. Or it seemed to. But on complete examination, it really doesn’t. You see, rebalancing doesn’t produce an automatic positive result each time. But most of the time it does. This article reconciles the new paper with others and explains why and how you should rebalance your portfolio.
Nevertheless, the principle is instructive. We don’t know an asset’s true expected returns, but we can observe its realized risks, and we can reason that assets that are similarly risky should have roughly similar expected returns. Thus, when sifting through assets that have fairly equal levels of risk and return, the odds favor selling the winners to buy the losers. One asset might temporarily look to be higher-returning than another, but the results likely will converge over time.
Implicitly, I’ve described mean reversion. Which is indeed what researchers find when documenting the behavior of financial markets. Although winners often remain winners over the short term, meaning for a few weeks or months, they tend to slide back when the time period extends past one year. Meanwhile, losers rebound. Intermediate-term mean reversion was initially documented for U.S. stocks over five-year time periods by Werner De Bondt and Richard Thaler in 1985 and has since been expanded to include asset classes as well as individual securities and to use a variety of time horizons.