2017 JPH FuturePlanner Scholarship Finalist: Tyler Floyd, Texas Tech University

Editor’s note: The following is a submission to the JPH FuturePlanner Scholarship, which is awarded to a deserving student in a financial planning-related graduate or undergraduate program nationwide. Part of the scholarship requirements include an article on a financial planning topic of choice, focused on how the chosen topic relates to current American trends or events. The views expressed are the author’s alone, and do not necessarily reflect the views of JPH Advisory Group. If you enjoy this article, please feel free to share it on your favorite social media platform, as part of the scholarship selection process includes the social media “buzz” that the article receives.

Is Rebalancing Right for Everyone?

by Tyler Floyd, Texas Tech University

The act of rebalancing is one that has come to the forefront of modern portfolio management. Financial professionals are tasked with the responsibilities of preparing, implementing and monitoring their client’s assets. These tasks are at the core of the financial services industry.

Preparing and implementing the client’s financial plan requires a mix of technical and soft skills that makes the client feel comfortable with their plan to acquire their ideal financial future. However, once this plan has been put in place, it is imperative that the monitoring phase begin.

With that in mind, is rebalancing the optimal strategy for portfolio management? If so, when is the optimal time to implement? How is this strategy going to impact our client’s emotional and financial well-being?

What is it?

Before I get into the validity of rebalancing, let’s have a quick overview. Rebalancing is a strategy employed by investors to keep their portfolios in the general ballpark of where they started. This “ballpark” is built from the pillars of risk tolerance and expected return. Markowitz’s Modern Portfolio Theory teaches us that risk should be rewarded with excess return over less risky alternatives.1 As a financial professional educates their client on the tradeoff between risk and return, the client will discover his/her target risk-return parameters.

The range of these parameters vary with client’s risk tolerance and goals. For example, a relatively risk averse client might feel comfortable with a 50% stock/50% bond allocation. Over time, this allocation will become skewed. If the market goes up, the client’s stocks go up in value, thus increasing the percentage of the portfolio allocated to stocks relative to bonds. Inversely, if the market goes down, the client’s allocation to bonds in relation to stocks would increase. While the client would choose for the market to go up ten out of ten times, neither scenario keeps the client at a 50/50 asset allocation. Enter, the rebalance.

In 1979, Daniel Kahneman and Amos Tversky created Prospect Theory. This theory states that investors are inherently risk averse regarding gains, and inherently risk tolerant regarding losses.2 Put another way, when things are going well, investors want to hold on to what they have and keep it relatively safe. On the flip side, when things are going poorly, investors want to seek risk to gain back what they have lost. With that being said, I am going to break down the act of rebalancing into the two pillars discussed previously: risk and return.


For the sake of this article, we will consider risk to mean volatility. While there can be risks associated with bonds (inflation, interest rate, etc.), most investors consider stocks to be the riskier investment of the two, and for most investors, that is true. Therefore, when designing and implementing a balanced portfolio, it will be made up of “risky” stocks and “non-risky” bonds.

Picture yourself as the 50/50 investor mentioned previously. For simplicity, we will say you have $100 in your portfolio, $50 in stocks and $50 bonds. Over the course of the year, the market does well, and you receive an 10% return on your equity investment. Big winner! You now have $55 in equities. Because bonds are inversely proportional to stocks, we will say the value of your bond investment is now $45. You are feeling good about how your stocks have done. However, you now have a 55/45 stock/bond allocation. We know that stocks are riskier than bonds, and you want to stay around 50/50. If the market were to fall tomorrow, you would have 55% of your money invested in equities, instead of the original 50% and a dollar amount higher than you are comfortable with will be subject to greater volatility.

The same argument can be made the other direction. Instead of receiving a 10% return on your equity investment, you suffered a loss of 10%. Sad! Now, you have $45 invested in stocks a value of $55 for your bonds. Instead of the market falling tomorrow, it comes soaring back. However, instead of 50% of your money being invested in stocks, only 45% is working for you. While this is not the same kind of risk as the previous scenario, you have just been subject to a different kind of risk, that of opportunity. Going back to Kahneman and Tversky, investors are more willing to accept risk during down markets to get back on top. In this scenario, if the portfolio is not rebalanced, investors are denied the possibility of experiencing higher gains due to their decreased percentage allocated to equities. The investor is also denied the privilege of being more risk averse when returns are high. As we all know, the market is volatile, and no matter which way this volatility takes your money, you are at risk. While this is a very rough estimation of market activity and bond valuation, it paints the picture of the increased risks of a non-rebalanced portfolio.


When looking at rebalancing from a distance, it is easy to think that selling winners will negatively affect return. For the average investor, it is natural to want to invest in what is performing well and sell what is performing poorly. This is a behavioral bias Larry Swedroe refers to as “recency.”3 This is a common trend in the investing world, especially from those without professional help. You cannot blame these performance chasers. It is a natural human behavior to believe in what is working. We will touch on the emotional side of rebalancing later.

Rebalancing seems like a strategy to solely minimize risk exposure and keep clients in their risk-return target area. However, research has shown that rebalanced portfolios traditionally outperform their non-rebalanced counterparts. William Bernstein refers to this additional return as the “rebalancing bonus.”4 In a study conducted by Morgan Stanley, stock and bond returns were acquired from the S&P 500 and Barclays Aggregate Bond Index respectively for 37 years (1977-2014). The research found that a portfolio rebalanced annually consistently outperformed a non-rebalanced portfolio over the long-term. In fact, a 60/40 rebalanced stock/bond mix outperformed its non-rebalanced counterpart by more than 10%. It should also be noted that rebalanced portfolios with stock allocations of 30% and higher outperformed a pure 100% equity portfolio.5

While I believe market timing is a hoax, mean reversion of a well-performing asset class is not a matter of if, but when. It is impossible to know with certainty when the market is going to correct itself, but when that time comes, a rebalanced portfolio can take advantage of a lower return environment. By rebalancing, you are not only helping your client stay within the parameters of their risk tolerance, but achieve higher returns, as well.

When Should It Happen?

There are a few different ways a client or financial professional may choose to rebalance a portfolio. Much like asset allocation, there is no perfect formula to determine how and when a portfolio should be rebalanced. Clients may not have a preference on rebalancing parameters, but it is up to the financial professional to find out if that is the case. Rebalancing without the input of the client can come with its own consequences.


A time-only rebalancing strategy is solely dependent on time elapsed between rebalancing. For example, a client may choose to have her portfolio rebalanced every month, no matter what returns look like. Annual, monthly, and even daily rebalancing can occur to keep a portfolio exactly where the client wants to be. However, this comes with its own tradeoffs. First, rebalancing costs money. Transaction costs are incurred every time a portfolio buys or sells an asset. While these costs will be minimal on a daily rebalancing schedule, they can add up quickly.

Rebalancing based on time also eliminates the opportunity to take advantage of momentum in the market. Bull markets can last for multiple years, even an economic cycle. The act of rebalancing frequently based on short periods of time takes away any momentum a portfolio might have. Many studies have been conducted to find the optimal rebalancing period. Some studies show once every two years to be best to consequently take advantage of market momentum. Others show that rebalancing monthly produces the highest returns. Others still have produced results showing quarterly rebalancing is most effective. A graph from Vanguard is given below based on returns from 1926-2009 showing their findings regarding time-only rebalancing.6 While annualized returns for never rebalancing shows higher performance, annual rebalancing is more effective when taking volatility into account. If one thing can be taken to heart from this research, it is that we do not have a definitive answer. Ultimately, it comes down to what the market is going to do in the future, and if we had that information, there would be no need to rebalance.

The allure of the time-only rebalance is in its simplicity. The easiest way to get your portfolio back on track is to have it set on a calendar. This requires no decision making or monitoring. Also, this strategy allows the portfolio to maintain its risk-return characteristics with precision and minimal fluctuation. A client who is extremely averse to volatility would benefit from this strategy.


In parameters-only rebalancing, thresholds are set to monitor a portfolio. For example, a threshold of 5% would require rebalancing when the value of equities rose from 50% to 55%. This could require rebalancing once a week, once a quarter, or once every 5 years.

The drawback of parameters-only rebalancing is that it requires constant monitoring of a portfolio. For an individual investor, this may not be the best option. However, for professionals with advanced software, this should not be an issue.

The biggest advantage of this type of rebalancing is the ability to react during big market fluctuations. In many instances, a year or more of solid returns precedes a recession. For example, in the year prior to our most recent recession from December of 2007 to June of 2009, the market performed at a gain of 7.7%.8 Investors that had rebalanced before the crash were not affected to the extent of those who may have waited until their rebalancing date. While it is not likely that a large negative downturn with the magnitude of the great recession will occur frequently, rebalancing a portfolio based on designated thresholds gives added protection to this possibility.


A combination of time and parameters rebalancing allows the investor to benefit from the advantages of each strategy. In this strategy, the portfolio is rebalanced within a certain period, but only if assets have strayed far enough for the investor to feel uncomfortable. For example, a client wants to reinvest every year, but only if her allocation has changed by more than 8%. If the portfolio was checked in a year and had only changed 5%, nothing would be done.

This strategy would be beneficial for those investors wanting to review their portfolio over a certain period, while also taking advantage of some market momentum. The threshold at which changes would be made is dependent upon the investors risk tolerance and return objectives. A client with a higher tolerance of risk and big goals for return might set their parameters at 10%. It should be known, however, that this investor may not touch change their portfolio for extended periods of time. Another graph from a Vanguard study is provided to show annualized returns based on thresholds of 1, 5, and 10% and time periods of monthly, quarterly, and annually. Average annualized returns seem to minimally outperform time-only rebalancing with similar volatility.6

It should also be pointed out that these systems of rebalancing can/should be used for assets within the equity allocation. Different types of equities will be purchased inside the equity allocation based upon risk and return requirements. These assets should be rebalanced, as well. I will go back to the 50/50 example. Let us assume that inside this 50% equity allocation, the client has 25% invested in emerging markets and 25% in domestic blue chip stocks. These are poorly correlated assets, meaning the movements of these stocks can change dramatically. If one asset becomes overweight, the other will be underweight. The same strategies employed to monitor and rebalance stock/bond portfolios should be used to rebalance assets inside the equity portion of the portfolio.

How Does It Affect Our Clients?

The stock market it a competitive place. Businesses are judged as winners and losers, portfolios are affected by gains and losses, and investors perceive their financial goals as successes or failures. Rebalancing, then, is counterintuitive of everything it means to be a competitor.

Rebalancing at its core is selling winners and buying losers. The adage of buy low, sell high is much easier said than done. When a stock price soars, a client will never call up their advisor and say, “get rid of it.” Those of us who study financial planning and portfolio management know rebalancing is the logical thing to do, but that doesn’t make it any easier for our clients.

While financial portfolios are not always akin to gambling, there are some lessons to be learned from the high-risk gambler. Using your imagination, picture yourself sitting down at a blackjack table in Vegas. You put $5 on the table, you win, you get $5 of the casino’s money. Instead of sticking with your $5 bet, you press your bet, and put your newly earned $5 in the betting circle as well. You win again. Look at you! You now have $10 of the casino’s money. You keep going and get on quite the roll and win 5 hands in a row, pressing your bet every time. You now have $160 in the circle, and your luck runs out. Instead taking the casino’s money and making it your own, you give it right back to them, along with your original $5.

This is what it is like to not rebalance your portfolio. Investors assume their equities will go higher and higher, so by not rebalancing, they continue to press their bet. It is so easy to keep going with what is hot, and so hard to pull the reins, but that is exactly what investors must do. As I said, the market is a competitive place. A reversion back to the mean will happen at some point, and the market is not going to care what money you have in the circle.

There have been many studies regarding behavioral issues with investors. Two studies come to the forefront regarding negative emotions regarding rebalancing.

Herd Mentality

In “Herding and Feedback Trading by Institutional and Individual Investors,” Richard Sias states, “Herding is defined as a group of investors following each other into (or out of) the same securities over a period of time.” This behavioral bias comes from investors watching investment news, reading mutual fund company ads, and listening to radio talk show hosts raving about the “hot sectors.” Rebalancing takes this mentality and flips it upside down. It is not easy to stray away from the herd, but those that do experience greater returns with decreased volatility.9

Regret Aversion

While the herd mentality highlights the behavioral issues associated with selling winners, regret aversion gives us insight into the reason buying losers is difficult. In their 1982 paper, “Psychology of Preferences,” Kahneman and Tversky concluded that we, as humans, have a desire to avoid admitting an error and realizing a loss.10 When we buy in the rebalancing process, we are accepting the fact that we have a loser in our portfolio. This is especially troubling if other sectors of the market are performing well. In this situation, it is very challenging for investors to make the rational decision to increase the losing position. Regret aversion tells us to pick something else, or stay out of the market completely. Rebalancing says give it a go.

How Do We Combat Negative Emotions?

The question for financial professional should not be, “how do I get my clients to not feel bad about rebalancing?” As Kahneman and Tversky point out, these are psychological feelings that are naturally experienced by rational humans. Instead, the question should be, “how can we make our clients feel comfortable enough to rebalance?”

The biggest combatant of these negative emotions is education. It is imperative for financial professionals to explain to clients before the fact that rebalancing doesn’t make sense to most people. Pointing out common behavioral biases and downfalls of many portfolios (buying high, selling low) will greatly increase the probability that the investor gets on board with rebalancing.

The fact that you are educating a client might not change his/her perception on the situation. Psychology is not the answer for everyone. These people need to see cold hard facts and data. Turns out, as discussed previously, rebalancing provides solutions for these people as well. Issues such as increased volatility through equity exposure can curb even the most analytical mind. At the end of the day, people want to make and keep their money, and what better number can there be than positive returns. Show the graph from Morgan Stanley, show the charts from Vanguard, show the effects of a non-rebalanced portfolio. These FACTS give insight into the benefits of rebalancing, and are useful tools in educating a client.


Bernstein states, “The actual return of a rebalanced portfolio usually exceeds the expected return calculated from the weighted sum of the component expected returns. It is demonstrated that assets with high volatility and low correlation with the remainder of the portfolio provide considerable excess return, or “rebalancing bonus.” So, is rebalancing an optimal portfolio management tool? The answer is yes. Is it for everyone? Still yes. However, the way in which rebalancing takes place can differ between investors. For most investors, a mix of time and parameter rebalancing should be used to generate higher returns with lower volatility. However, more research needs to be done regarding the optimal period for rebalancing. Financial professionals must realize that rebalancing is a powerful investment tool, but one that is difficult for clients to understand. It is the job of the advisor to educate and communicate the reasons behind rebalancing to ensure cooperation of the client and success of the portfolio.




  1. Markowitz, H.M. (March 1952). “Portfolio Selection”. The Journal of Finance. 7 (1): 77–91
  2. Kahneman, D., Tversky, A (1979). “Prospect theory: an analysis of decision under risk,” Econometrica, 47, (2): 263–291
  3. Swedroe, L. (2015, May 22). Avoid the Recency Pitfall. Retrieved May 3, 2017, from http://www.etf.com/sections/index-     investor-corner/swedroe-2?nopaging=1
  4. Bernstein, W. J. (n.d.). The Rebalancing Bonus. Retrieved May 1, 2017, from http://www.efficientfrontier.com/ef/996/rebal.htm
  5. Morgan Stanley. (2015, September 16). The Rebalancing Effect. Retrieved May 2, 2017, from http://www.morganstanley.com/articles/rebalancing-effect
  6. Jaconetti, C. M., Kinniry, F. M., Jr., & Zilbering, Y. (2010, July). Best Practices for Portfolio Rebalancing. Retrieved May 4, 2017, from https://www.vanguard.com/pdf/icrpr.pdf
  7. Banerjee, P. (2014, June 19). Portfolio Rebalancing: Why, When, and How Much. Retrieved May 4, 2017, from http://www.moneysense.ca/invest/portfolio-rebalancing-why-when-and-how-much/
  8. Carlson, B. (2015, March 15). Stock Performance Before, During, & After Recessions. Retrieved May 4, 2017, from http://awealthofcommonsense.com/2015/03/stock-performance-before-during-after-recessions/
  9. Sias, R. W., & John, N. R. (1999). Herding and Feedback Trading by Institutional and Individual Investors. The Journal of Finance, 55(6), 2263-2295. doi:10.1111/0022-1082.00188
  10. Kahneman, D., & Tversky, A. (1982). Psychology of Preferences. Scientific American, 246(1), 160-173. Doi:10.1038