RAFI: The Danger in "Debalancing"

August 03, 2015

Eat a balanced diet. Drilled into our brains since preschool, this advice falls squarely in the “duh, everybody knows that” camp. But it’s not just kids who need reminding. Parents and grandparents, as role models and dietary enforcers, do too. Common sense alone tells us this universally applicable dictum is the right way to eat. Different foods have different nutritional and caloric values. If we eat a wide variety of food groups, or as a five-year-old child is taught, “Eat a rainbow,” good nutrition is likely to take care of itself.1

The hardest part of colouring in the rainbow for most eaters is adding the greens, yellows, and oranges that represent fresh fruits and vegetables. Everyone has an excuse: the taste, the texture, the expense. We try our best to make fruits and veggies more appealing to ourselves and to our children. One seemingly easy option is to eat pre-packaged dried fruit or veggie chips. Both can be quickly packed for school or work lunches, and many prefer the taste. Yeah! Balance achieved. Or is it?

Indeed, closer examination finds that the drying and packaging processes can significantly diminish the health benefits of fruits and vegetables. The drying process concentrates the sugars in the fruit so if we eat the same amount of dried as we do of fresh, the amount of sugar we’re consuming skyrockets. And for some fruits, such as cranberries, sugar is even added to counteract natural tartness. As for veggie chips, they have many more calories than their fresh counterpart, while adding salt and fat and subtracting vitamins. Our well-intentioned effort to maintain or improve dietary balance actually backfires. Our imbalances are only exacerbated through poor substitution!

Likewise, investors intuitively understand that they should broadly diversify the portfolio of assets that they hold. In other words, their asset allocation should “look like a rainbow.” But maintaining the optimal level of diversification is hard. As our colleague Jason Hsu says, “Diversification is the strategy of maximum regret because some part of the investor’s portfolio is always underperforming its benchmark!” For most investors, staying diversified is like trying to get a five-year-old preschooler to eat broccoli—it’s just plain “yucky” despite all the well-meaning, repeated pleadings of advisors and parents, respectively.

Our Investment Beliefs In Action: Rebalancing

Last fall, in concert with the release of Research Affiliates’ interactive Asset Allocation site,2 we published our investment beliefs. These beliefs share a central philosophy: the largest and most persistent active investment opportunity is long-horizon mean reversion.3 The one investment activity that flows from this central assertion is rebalancing, a contrarian exercise that forces the investor to sell recent winners and buy recent losers. There are two key reasons to undertake this inherently uncomfortable trade:

1. Excess Return. Although each instance of rebalancing is not perfectly timed to produce a massive windfall, or even to make money, over the course of a portfolio’s life as the mean-reversion cycle plays out and the investor repeatedly sells recent winners and buys recent losers, excess return should be generated. Rebalancing, when practiced consistently over time, has been demonstrated to produce long-term excess return in a broadly diversified portfolio.4 Rebalancing also allows investors to potentially realize a higher dollar-weighted return because of an increased exposure to a security or sector after its recent poor results and before a subsequent performance uptick, and vice versa. Not surprisingly, this activity is hardwired in nearly all of Research Affiliates’ investment solutions, from our RAFI™ strategies to our work in GTAA.

2. Targeted Risk. Rebalancing keeps a portfolio’s risk posture at the desired level; for example, rebalancing back to a 60/40 equity/bond allocation maintains the portfolio’s volatility at approximately 10%. After a period in which stocks have outperformed, the equity allocation will likely rise above 60%, causing the portfolio to have a higher risk profile than desired. Conversely, when bonds have outperformed, the bond allocation will be larger than desired, causing the portfolio’s risk profile to fall below the targeted 10%.

So whereas rebalancing may not achieve excess return in every instance, its ability to fine tune the risk posture of a portfolio is more or less a constant, if underappreciated, benefit of the practice.

 

 

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