Rebalancing Through Market Drawdowns
Key Insights
- Although investors may be reluctant to add to higher-risk exposures in a market drawdown, we believe it is essential to maintain a prudent rebalancing approach.
- Our analysis of historical and simulated market drawdowns suggests that rebalancing potentially improves outcomes relative to a non-rebalanced portfolio.
- We believe investors should select the rebalancing rule that they think is most appropriate and adhere to it through all periods, including market drawdowns.
Rebalancing asset exposures is fundamental to prudent portfolio management and has long been considered a key determinant of long‑term performance. Regularly reorienting to targeted long‑term asset allocations helps ensure that all risk exposures in the portfolio are intentionally accepted. However, many investors may be reluctant to follow their normal rebalancing policies in periods of market stress, when adding to higher‑risk exposures may seem particularly unpalatable.
We believe it is essential that investors maintain a prudent rebalancing approach. Our analysis of both historical and simulated equity market drawdowns found that sticking to an investment policy’s rebalancing rule typically led to better outcomes when compared with a passive strategy of allowing portfolio exposures to drift with market movements.
In this paper, we analyze the impact of various rebalancing methods in both historical and simulated market drawdowns. We compare various rebalancing rules: two of them calendar‑based (monthly and quarterly) and two that rely on exposure bands (±2.5% and ±5.0%). Our findings suggest that during market drawdowns and subsequent price recoveries:
- Using Monte Carlo analysis, we found that all of the rebalancing rules we tested outperformed a non‑rebalanced portfolio in at least 90.9% of simulated scenarios.
- In our simulations, certain rebalancing methods potentially outperformed others during specific types of market drawdowns. However, it is impossible for investors to know in advance the type of drawdown they are experiencing.
- Our simulations suggested that there is no “silver bullet” rebalancing rule, given the multiple considerations that need to be addressed when designing and maintaining rebalancing policies.
We believe investors should select the rebalancing approach that they believe is most appropriate for them, given their own circumstances, and adhere to it through all periods, especially during market drawdowns and recoveries.
We believe it is essential that investors maintain a prudent rebalancing approach.
The Importance of Rebalancing
Establishing and implementing a portfolio rebalancing policy is widely believed to improve portfolio performance over full market cycles. Over rolling 10‑year periods since 1989, any of our four rebalancing methods would have outperformed a hypothetical non‑rebalanced portfolio. Figure 1 shows the average cumulative excess returns and hit rates (the percentage of all rolling periods in which the hypothetical rebalanced portfolio would have outperformed) for the various hypothetical rebalancing methods versus a hypothetical non‑rebalanced portfolio with assumed initial allocations of 60% to global equities and 40% to U.S. bonds.
The hypothetical rebalanced portfolios would have outperformed a hypothetical non‑rebalanced portfolio in a large majority of the historical 10‑year rolling periods covered in our study, ranging from an 88.0% hit rate for a monthly rebalancing rule to a 89.6% hit rate for a rule that sought to keep relative exposures within ±2.5% bands. The average margin of cumulative excess return would have ranged from 4.22 percentage points (for monthly rebalancing) to 6.07 percentage points (for a rebalancing policy based on ±5% bands).
Assuming a hypothetical starting portfolio balance of USD 1,000,000, the average improvement to ending balances from adhering to one of the rebalancing rules we tested would have ranged from USD 42,199 to USD 60,652.
Hypothetical Rebalanced vs. Non-rebalanced Portfolios1
(Fig. 1) Hit rates and average cumulative excess returns over rolling 10-year periods
January 31, 1989, through March 31, 2020.
1 Initial portfolio weights: 60% equity/40% bonds. Equities represented by the Morgan Stanley Capital International All Country World Index (MSCI ACWI); bonds by the Bloomberg Barclays U.S. Aggregate Bond Index. The results shown above are hypothetical, do not reflect actual investment results, and are not indicative of realized past or future performance. See appendix for rebalancing methodology.
Sources: MSCI and Bloomberg Index Services Limited (see Additional Disclosures); all data analysis by T. Rowe Price.
Stick to the Policy Even During Market Drawdowns
Despite the potential benefits of adhering to clear portfolio rebalancing rules, investors may be tempted to abandon their rebalancing policies during market drawdowns to avoiding buying into falling markets. To examine the potential pitfalls of such an approach, we analyzed our four rebalancing methods in a sample of historical and simulated market sell‑offs.
Important Information
This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.
The views contained herein are those of the authors as of May 2020 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.
This information is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.
Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.
Past performance is not a reliable indicator of future performance. All investments are subject to market risk, including the possible loss of principal. All charts and tables are shown for illustrative purposes only.
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