Countercyclical Indexing is a low cost and tax efficient indexing strategy that focuses on rebalancing a portfolio over the course of time to create more appropriate returns. For instance, a 50/50 stock/bond portfolio will tend to grow into a 60/40 stock/bond portfolio over time because the stocks will outperform the bonds. The investor who rebalances back to 50/50 is readjusting their risk profile to account for the fact that they are now exposed to more stock market risk than their profile originally designed for. Thus, rebalancing is an essential part of risk profile consistency.
Risk profile consistency is important because it is a behavioral control mechanism. If your portfolio exposes you to more or less risk than you are comfortable with then you risk making behavioral mistakes (selling into downturns, chasing returns, etc). Therefore, rebalancing is an important element in achieving behavioral alpha (superior performance through disciplined investing) and good behavior is a crucial piece of any good asset allocation plan.
Further, as Sharpe, Arnott and Bernstein have noted, there is a “rebalancing bonus” that comes from periodically shifting a portfolio away from its unnatural setting.¹²³ This makes sense since a portfolio that perpetually grows into a stock heavy portfolio cannot be an efficient risk management portfolio since the equity market cannot mathematically become the entire pool of financial assets. Therefore, the investor who allows their portfolio to grow into an increasingly overweight stock portfolio is creating a portfolio that takes more risk rather than more risk adjusted return.
We rebalance for a simple reason – the empirical and behavioral evidence shows that it is an essential and beneficial element in any portfolio. We have found this to be particularly true over the course of our research and professional management – rebalancing works because it is a behavioral tool that helps us maintain more suitable and sustainable portfolios as opposed to constantly wasting high fees chasing the ever elusive optimal portfolio.
¹ – Andre F. Perold and William F. Sharpe, “Dynamic Strategies for Asset Allocation” Financial Analysts Journal (January/February 1988):16-27.
² – Robert D. Arnott and Robert M. Lovell, “Rebalancing: Why? When? How Often?” The Journal of Investing 2, no. 1 (Spring 1993): 5.
³ – Bernstein, William. The Rebalancing Bonus: Theory and Practice.