Why I am skeptical about the “rebalancing bonus” even though I believe that “buy, hold, and rebalance” is a great investment strategy

This past week, Rick Ferri, the Founder of Portfolio Solutions, wrote an interesting blog post on Forbes.com titled “Passive Investing Beats the Markets”. In the post, Mr. Ferri argues that a buy, hold, and rebalance strategy using low cost index funds outperforms a number of other strategies including an index-based strategy of buy, hold, and never rebalance.

In a related discussion on Bogleheads.org, Mr. Ferri provided some historical data supporting this conclusion, but I thought I would take a stab at running some simulations to better understand the conditions where rebalancing can boost total returns.

The Bernstein Analysis of the Rebalancing Bonus

In 1997, William Bernstein published an analysis on his website which showed how the “rebalancing bonus” was affected by the difference in average returns between two securities and the correlation between those returns.

Bernstein’s analysis showed that rebalancing can increase returns when two volatile securities have similar average returns and low correlation. The intuition behind this result is straighforward, if two securities are highly correlated, then there is little opportunity to transfer funds from the security which is performing relatively well to the security that is performing relatively poorly. If the securities have low correlation, then there are more frequent opportunities to “buy low, sell high” through rebalancing.

Similarly, if the two securities have very different average returns, then the rebalancing will, on average, move funds from the security with higher average returns to the security with lower average returns. This is obviously not a strategy which will boost total returns over time, although it may make sense for risk management purposes.

Continue reading »