August 9, 2017 9:41 am

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Charlie Morris: Rebalancing transactions brings you back to your original asset allocation at the start of the last period. Over the long term, rebalancing transactions are shown to have added value because of “mean-reversion.” That means assets that did well tended to ease back, while assets that did badly, recovered. This works best at a high level – as in asset allocation between bonds and equities or equity weights within a diversified equity portfolio.

The strategy was made famous by David Swensen, the chief investment officer at Yale University. He used rebalancing and forecast it would add 0.4% per annum, on average and over time, to Yale’s endowment scheme. It works because you take advantage of market noise. If share prices sell off due to events such as Brexit, the election of Donald Trump, an earthquake or a terrorist attack, the likelihood is that they will rebound.

That’s because those events do not have a material long-term impact on future corporate profitability. If there is a panic, bonds will likely rise and shares likely fall. The subsequent rebalance will sell bonds and buy shares. If shares continue to fall and bonds rise, the rebalance will result in loss.

However, unless stocks or bonds fall to zero, it will be right eventually. Imagine you invested 60% in UK equities and 40% in gilts since 1991 (I chose 1991 because the data is readily available). From the end of 1991 to 12 December 2016, the FTSE All-Share total return (including dividends) returned 648% and gilts 525%.

If you never rebalanced, you returned 599% or 8.1% per year. Your allocation would be 64% in equities and 36% in bonds today.  If you rebalanced at the end of each year, you returned 661% or 8.5% per annum. Your allocation would be 61% in equities and 39% in bonds today. There it is.

Swensen’s 0.4% excess annualised return demonstrated in the UK market. I landed on it on my first attempt and didn’t seek it. To do even better, you rebalance after extreme moves rather than at fixed time intervals. This is an effective long-term strategy for institutional investors.

Should private investors do it?  I’d say it’s more for Soda than Whisky. I would only make changes if they are meaningful.