Foster Group

Alchemists, according to legend, were both scientists and magicians, able to turn desert sand into gold.  They took something plentiful, and of little or no value, and transformed it into the most valuable commodity of the age. 

A July/August 2011 Financial Analysts Journal article* by University of Illinois Professor Scott Willenbrock references a thought-provoking example of what seems like modern-day alchemy; what he calls the "Diversification Return" that can be realized through the practice of portfolio rebalancing.  He cites the result of a simulation by researchers Erb and Harvey who created 40 hypothetical uncorrelated assets, each with an average annual return of 0%, but a standard deviation of 30%.  You could say that these 40 investment assets were "sand," in that they had no positive long-term return.  Willenbrock summarizes their findings this way: 

"Running 10,000 simulations over 45 years, they found an equally-weighted, rebalanced portfolio had an average return of 4.3%.  They dubbed this result, "turning water into wine." *

It was portfolio alchemy!  Each portfolio asset had a total return of 0% (e.g., worthless sand) for the period.  But the portfolio of all 40 assets combined produced a positive return of 4.3% (e.g., gold).  How is this possible?  Regular rebalancing is the answer.

Foster Group has consistently advised clients to allow for the regular rebalancing of their investment portfolios regardless of the near-term investment environment.  The basic premise of rebalancing is that investors have increased success when they "buy low" and "sell high," adopting a consistently dispassionate, almost contrarian viewpoint.

Here's an example of how it worked in the very volatile two-year period ended December 31, 2010.  If the investor had simply owned the S&P 500 for the period, they would have experienced an average annual return of -2.86%. Had the investor invested only in US small companies, represented by the Russell 2000 index, they would have experienced a 2.22% annual return.  If a third investor had only held US real estate investment trusts, as represented by the Dow Jones US REIT index, their return would have netted an annualized 0.01%.  A fourth investor, very cautiously invested in only short-term US Treasury bills, would have been rewarded with a 0.63% annual return.

But a fifth investor - the "portfolio alchemist"- who utilized regular rebalancing, could have seen their return for the period, using these same more or less "sandy" assets, grow by 2.68%.  How?  If the fifth investor had simply held these assets in equal weights (25 cents of each dollar to each asset class), and every six months "rebalanced" back to the 25% target, selling the assets that grew and buying the assets that declined, the rebalancing "alchemy" could take place.  This "alchemy" provided a better result than any of the individual investments over the 24-month period.

Additionally, the rebalanced portfolio exceeded a simple buy-and-hold approach where an investor took a 25% position in each of the assets in 2008, making no further buys or sells over the two-year period.  The buy-and-hold portfolio would have produced a 0.04% annualized return vs. the 2.68% return of the rebalanced portfolio.

Admittedly, testing portfolios in differing time periods with different rebalancing intervals yields a variety of results.  But the principle confirming the potential value of rebalancing has been shown to hold in most all investment environments and time periods where the outcome of what will turn out to be the “best” investment can only be known in retrospect.  In today's uncertain financial markets, investors can be tempted to hold onto every last penny of bonds and cash in the face of very volatile, often declining, equity markets.  However, long-term portfolio success can be enhanced by the regular practice of rebalancing to the Investment Policy allocation suitable to the individual investor’s circumstances and goals.  Yale University Endowment portfolio director David Swensen calls it, “the  rebalancing bonus."  Willenbrock describes it as the "free dessert" of portfolio management.  Either way, it works a bit like the legendary alchemy of old.

*Willenbrock, Scott. 2011. “Diversification Return, Portfolio Rebalancing, and the Commodity Return Puzzle.” Financial Analysts Journal, vol. 67, no. 4 (July/August): 42-49