Why we rebalance and other tales about volatility

Investing / Portfolios
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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…

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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.