Why we rebalance and other tales about volatility

I never really questioned the recommendation to rebalance portfolios periodically to maintain the 60/40 stock/bond split. Is it just because the bond portion reduces the overall percent impact of a stock downturn?

No, there’s way more to it than that. One of the important bits is rebalancing. By rebalancing periodically, we reduce the impact of volatility on the compound growth of the portfolio over time (aka your wealth).

I’m pasting some references below that I think will be interesting to passive investors who want to know what’s going on with their portfolios. At the end of the day, you’ll probably just buy and hold in exactly the same way, but with more confidence :smiley:

Intuitively, we know that losing 10% means we need to make ~11% the next year just to break even. The Volatility Drain - Party at the Moontower expands on this and frames it as a difference between arithmetic and geometric mean of the returns over time.

https://breakingthemarket.com/the-arithmetic-return-doesnt-exist/ explains why rebalancing alleviates the problem and reduces the impact of volatility on the compound growth.

https://twitter.com/bennpeifert/status/1362908508237090816?s=21 shows how a portfolio with a negative-return asset can actually grow more than one without it. But this is a topic for another thread…


Thank you, happy to see some thoughts about multi- asset portfolio and the power of rebalancing. The above lead to higher risk-adjusted return and through this higher Portfolio efficiency.

Just in response to the „maximizing total return“ fellaws out there. Have a look at this:

Indeed, a 1.5 leveraged 60/40 (ordinary 90% shares and 60% treasury overlay) might be a slightly unwise choice in an interest reverse scenario… but as long as we assume long term stable, or only moderately increasing interest rates… such fund should beat 60/40 on absolute return; whilst exposing comparable efficiency aka risk/return characteristics of a 60/40. Such 60/90 might even lead to close to the absolute return of 100% shares.

To offset the risk of raising interest rates, an interesting thought may be to take out:

  • 65% 1.5 leveraged 60/40 to 90/60 (gives you about 60% of shares return)
  • 10% Gold (gives you currency de-valuation protection)
  • 10% Cash / Money Market (gives you interest rate shock protecion)
  • 15% Regulated, Monopolized Infrastructure Utilities e.g. Electronics Grid, Water, subsidizes Green Energy or Non-Profit Societies‘ Equity (gives you real inflation protection and given massive long term debt reduces your Portfolio duration)

Convinced that as long as we don‘t talk about end of world scenarios; such Portfolio would over the long run crunch either 60/40 or 100% shares strategies.

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There was this post of Big ERN that listed some of these points.
It also touches on the possiblity of using multi-asset porfolio and leverage to have the same expected return with lower volatility (more details in this one). Certainly an interesting topic, but too far out of my comfort zone.

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Many thanks in particular for a very timely link to this blog. I was scratching my head thinking about similar questions.
I recommend to read it to everyone with hard sciences background trying to understand investing concepts (like me).

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Yeah, interesting thoughts. There are some ETFs that implement the levered strategy (eg NTSX for 90/60) and the expense ratio is not even that bad (0.2%).

The problem with all this portfolio theory is that the correlation ends up turning against you at the worst moment when you need it the most. In a downturn, low or even negative correlations increase, and you realize you had taken on way more risk than expected.

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