What would you do if you decided to invest 50% of your portfolio in stocks and 50% in bonds but after one year your stock doubled and your bond assets remained the same? In that case, 75% of your assets will now be in stocks, which will increase the short term risk of your portfolio. Stock prices already reflect all available information and markets are a random walk in the short-run. In other words, the fact that the stock market boomed last year says nothing about this year's stock returns. Therefore, what would you do? The strategy of rebalancing a portfolio is commonly used for investors looking to decrease such risk.
The basic idea is around portfolio rebalance is to redistribute your allocation of resources when the basket of one product begins to overflow so that your portfolio remains efficiently diversified. Therefore, you would be sporadically checking the distribution of your assets and relocating them according to your initial strategy. In the case above, the investors would have sold part of their stocks and used such capital to buy bonds so that their portfolio returned to a 50/50 strategy (50% stock, 50% bond). Minor fluctuation in a portfolio distribution, like plus or minus 10 percent fluctuation, should probably be ignored (Malkiel and Ellis, 2013), given that there are financial costs associated with buying and selling assets and the risk reduction that would be achieved would be small. However, rebalancing major fluctuations decreases the volatility of your portfolio and often improve your returns.
For example, let's suppose you followed Siegel (1994) advice for conservative investors in 1996 and decided to allocate 60% of your 10-year investments in stocks and 40% in bonds. If you had just left these investments without touching them until 2005, they would have returned 8.08% per year, on average, with a standard deviation (a measure of risk) of 10.05. If you had rebalanced those same investments annually so that it maintained the 60/40 distribution you initially stipulated, you would have had an 8.46% annual return with 9.28 volatility. In other words, you would have had higher returns and lower risks (Graph 1). These calculations were made using a US total stock market index (Russel 3000) and a US total bond market index (US aggregate).
Graph 1. 1996-2005 Investment Portfolio Comparison
Note: Malkiel and Ellis (2013)
It is important to highlight that rebalancing does not necessarily increase your returns. However, it will always decrease your risks! Eligible clients can have their portfolios rebalanced by Moraya Consulting without costs through our Private Wealth Management. Check all our products!
- Malkiel, Burton Gordon., and Charles D. Ellis (2013). The Elements of Investing: Easy Lessons for Every Investor. Hoboken, NJ: John Wiley & Son Inc.
- Siegel, Jeremy (1994). Stocks for the long run: the definitive guide to financial market returns and long-term investment strategies. New York: McGraw-Hill.
IMPORTANT: THERE IS NO ONE BEST TAX OR INVESTMENT STRATEGY. IT ALL DEPENDS ON YOUR GOALS, RESOURCES, AND CITIZENSHIP.
For example, are you willing to move abroad? If so, where? How long do want to stay in each place? What is your annual income? How much money are you willing to invest? Do you want short term gains or long-term investments? What is (are) the source(s) of your income? How much taxes do you pay annually? Do you want to decrease your tax duties or completely remove them? Do you feel like you want to pay some taxes even if you do not need to? What is your citizenship? Do you have multiple citizenships? Depending on each of these answers the best investment/tax strategy for you will differ. In order to see what option is best for you and to help with the implementation of the strategy feel free to reach out to us. You do not need to be rich to create a global investment portfolio. Most of the bank and brokerage accounts we open do not have minimum initial deposit or maintenance fee. Thus, you can invest as much as you want or even leave the accounts empty until you have enough capital or interest to invest abroad.