Optimal Rebalancing Frequency for Stock-Bond Portfolios

Abstract

This paper examines the effect of investors’ portfolio rebalancing frequency and out-of-balance threshold on the portfolio’s scaled return (return/risk ratios). Using data from 1926-2003, we examine the return/risk ratio for 19 different stock/bond portfolios with policy weights of 5%/95%, 10%/90%, and so on through 95% bond/5% stock. For each of these 19 portfolios, we calculate scaled return (mean return  standard deviation of return) under 60 different time-based policies of rebalancing every 1 month, 2 months, and so on through 60 months. Next, we examine 20 threshold-based policies involving rebalancing when portfolio weights deviate from policy weights by 0.5%, 1%, and so on through 10%. Finally, we conduct both analyses again under two distinct Federal Reserve monetary policies: expansionary and contractionary.

Our conclusions are as follows. Rebalancing frequency and threshold have a significant effect on scaled return. Specifically, for many model portfolios examined, deferring rebalancing to even as long as four years was superior to a monthly or quarterly rebalancing policy. For percentage threshold-based policies, the superior (inferior) outcomes were associated with rebalancing only when portfolio weights were 5% or more (less than 5%) out of balance.

From the perspective of both frequency and threshold levels, patient rebalancing policies tend to dominate quick-trigger policies, even before trading costs and taxes are considered. If such costs were taken into account, the advantage in favor of patient policies would be even more dramatic.

The best rebalancing policy is dependent on, and can be planned around, the Fed’s prevailing monetary policy. We find that Federal Reserve monetary policy has a discernible impact on scaled returns due to rebalancing, with restrictive monetary periods associated with less ambiguous conclusions. During restrictive periods, rebalancing more frequently than every 10-20 months is a suboptimal strategy.

Why does a relatively long time interval (and higher threshold) for rebalancing outperform a shorter time period (and lower threshold)? One, partial, explanation comes from the observation by various researchers including Poterba and Summers (1988) and Fama and French (1988), of positive short-term autocorrelation among stock returns and negative longer-term autocorrelation. To the extent that returns are positively correlated in the short run, investors can take advantage of momentum by sitting tight. In contrast, mean reversion in returns over 3-5 years confirms the efficacy of rebalancing about that often.