Since Rebalancing Makes So Much Sense And Empirically Has Been Shown To Increase Portfolio Value, Why Don't More Investors Do It?

Wednesday, August 01, 2012 07:27
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Since Rebalancing Makes So Much Sense And Empirically Has Been Shown To Increase Portfolio Value, Why Don't More Investors Do It?

Tags: asset allocation | plan execution | rebalancing

There’s plenty of research proving that rebalancing portfolios is a smart thing to do. So then, why don’t more investors do it? Because, in the terms of behavioral finance, normal people are not as sensitive to risk on the front end as they are after the fact. They also have risk aversion that inhibits them from taking money from well-performing assets to put it into worse-performing assets.

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This causes them to focus on things other than investment returns. Even institutions don’t seem to be able to master the skill of buying low and selling high. And a large body of research shows that, over the long-term, assets tend to exhibit long-horizon price mean reversion.
 
An example is when the S&P 500 index goes down in value, its dividend yield increases. There is empirical evidence that, after five years, returns on the benchmark index tends to beat average returns significantly.
 
From a behavioral perspective, investors whose assets have fallen in value tend to be more risk averse and are reticent to add more perceived risk to their portfolios by investing in beaten down assets.
 
Those whose wealth increases tend to be more risk taking and tend to speculate even when asset prices are already high. These tendencies defy the buy low-sell high mantra, despite academic proof that it works.
 
So what are we as advisors to do? Statistics show that, regardless of asset size, long term returns are improved when portfolios are rebalanced after significant price movements. If you can get your clients to truly adopt a long-term view, then rebalancing is a fabulous way to build wealth.
 
Otherwise, we have to realize that the market can stay irrational longer than we can remain employed—or stay married. These days, it may be more prudent to bet on employment as the longer term factor than staying married!

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