Strategic Risk Management

CHAPTER 4Strategic Rebalancing

INTRODUCTION

The previous chapter established that an active portfolio construction technique, volatility targeting, was particularly effective for risk assets in reducing downside exposure. There are two additional techniques that we will examine: rebalancing and drawdown control.¹

We cover rebalancing in this chapter. Almost all investors rebalance their portfolios. Rebalancing is one of the most widely accepted portfolio management tools. However, we will argue that rebalancing is poorly understood. If implemented in a naïve, mechanical fashion, it can increase the risk of your portfolio. For example, if the equity market is in a prolonged selloff, rebalancing will be purchasing additional equity all the way down—increasing the size of the drawdown.

That said, a pure buy-and-hold portfolio has the drawback that the asset mix tends to drift over time, making it untenable for investors who seek diversification. As illustrated in Figure 4.1 for a U.S. stock-bond portfolio, an initial 60 percent of capital allocated to stocks in 1927 drifts to a 76 percent allocation by 1929, a 32 percent allocation by 1932, and a level close to 100 percent over time, as stocks tend to outperform bonds over the long run. So, obviously, an unrebalanced portfolio will eventually lead to the portfolio being undiversified by being concentrated in the high risk–high expected return asset.

However, a stock-bond portfolio that regularly rebalances tends to underperform ...