Investing is the ultimate exercise in patience. The passage of time has historically delivered, on average, positive returns for major equity and bond markets, and over the years the compounding of these returns has proven a strong creator of wealth.

To realize these potential long-term benefits, one must endure the challenges posed by the short-term uncertainty inherent in securities markets. One such set of decisions involves transacting, which includes: initiating positions; rebalancing to a targeted asset allocation; or selling assets to raise cash or begin decumulation. An undisciplined approach to trading decisions, particularly during volatile market conditions, can negatively impact performance and make for a difficult investing experience.

DISCIPLINED APPROACH

By exploring several alternate rules and their effectiveness in the context of history, we can suggest best practices for implementing investment portfolios. In our opinion, a disciplined approach that requires rebalancing portfolios annually can create additional return potential and lower volatility versus never rebalancing.

For a long-term investor, patience and risk management are essentials. It is also important to differentiate patience from inattention. Maintaining a mix of investments delivering returns and risks consistent with a client’s needs requires timely adjustments, as many common occurrences within a portfolio serve to move it off its initial asset allocation.

Performance is one such natural influence. As assets rise or fall in value, their weights also change based on how they have performed relative to the portfolio. In other words, portfolios will see rising weights in asset classes that have outperformed, and falling weights in those that have underperformed. So, portfolios that are not rebalanced will typically be overweight assets with the strongest trailing performance. Often, these can be risky due to higher embedded expectations or richer valuations. Thus, investors who don’t rebalance may find themselves overexposed to rich asset classes and underexposed to cheap ones.

PORTFOLIOS GO ASTRAY

While perhaps surprising, this is intuitive considering that, in the absence of rebalancing, a portfolio can significantly stray from its initial allocation. We examined this phenomenon over recent history. We initiated a 60% stock/40% bond portfolio beginning in 1977, and let the portfolio grow with no rebalancing (see chart). This sample portfolio would have been both overweight equities— having an allocation greater than 60%— despite the fact that the asset class was generally more expensive than long-term history; the median forward price/ earnings ratio since 1977 is 16.

Conversely, prior to market tops, the sample portfolio was generally underweight equities despite the asset class’ attractive valuation. In each of these cases, rebalancing to establish an allocation closer to target would have had a meaningful benefit to performance.

BEHAVIORAL BIASES

Additionally, behavioral biases can affect capital allocation. Given flows of new capital, investors must decide on an appropriate allocation. Investors often overweight asset classes that have outperformed recently in hope of continuing this outperformance. Alternatively, this can also lead to selling out of asset classes when their markets have declined. Emotional views of performance do not constitute well-reasoned investment opinions. Left unchecked, these decisions can affect allocations and potentially harm performance.

Finally, investors often elect to reinvest the income produced by a specific investment product back into that same product. This encourages greater savings, as reinvesting income within the portfolio can build value more effectively than simply distributing the income, or letting it sit in cash or short-duration fixed income that is easily withdrawn. However, income returned to its source asset class rather than holistically deployed can skew weights toward classes with greater income-generation potential.

VALUE FROM VOLATILITY

Investing is also a trade-off between risk and return. Bearing the risk of uncertain asset values helps create long-term growth of asset prices. In this manner, risk is viewed in a negative light, as more uncertain returns can, in adverse circumstances, equate to losses, and requires a reward to be such that investors are compensated.

An alternate view casts volatility with the potential to create value. Over the very long term, and under a disciplined rebalancing regime, volatility can be “harvested” to benefit wealth creation through rebalancing across overvalued and undervalued cross-sectional price differences over multiple periods. As an example, the chart above shows two longterm constructions of domestic stock and bond portfolios of different mixes. Here, we compare the differences in value after 20-plus years and note that the rebalanced version has significantly outperformed the version that was not rebalanced. In addition, a 60% stocks/40% bonds portfolio rebalanced annually has outperformed a static 100% stock portfolio.

LIGHTENING UP, TOPPING OFF

How can this modest amount of rebalancing create such significant value? In essence, rebalancing in this manner takes advantage of the long-term effects of mean reversion. By lightening up on stocks after periods of significant outperformance, or topping off positions after periods of underperformance, this discipline helps take advantage of volatility to benefit from these swings. Note this does not require any insight over which asset class will outperform in any given period—only that a disciplined approach dictates a fixed mix of portfolio assets, as well as a set interval during which rebalancing takes place.

Following periods in which an asset class meaningfully outperforms, portfolios will likely be overweight that asset. As a consequence, they will have strayed from the original allocation, which can change the portfolio’s risk profile. Rebalancing back to the original allocation restored the original risk profile and reduced volatility across different stock/bond allocations historically. This annual rebalancing would have prevented a portfolio from being overweight equities or bonds at the end of a bull market, thus reducing volatility into a correction. It would have also restored the portfolio’s allocation after a major correction, which would have helped returns.

The benefits from rebalancing extended beyond improved returns. Rebalancing following declines in stocks by definition means buying more stocks. It would not be unreasonable to suppose that buying into corrections and bear markets would raise the volatility profile of a stock/bond portfolio. Historically, however, this has not been the case—annual rebalancing has actually suppressed portfolio volatility.

For a full copy of the special report, “Staying on Course: the Value of Rebalancing,” please contact your Financial Advisor.

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© 2015 Morgan Stanley Smith Barney LLC. Member SIPC.