Why investors are poorly suited for managing long-term returns.
For investors, the $1 million question is, “Why don’t all of us rebalance?” Research shows compellingly the long-term benefit of rebalancing, yet anecdotal evidence suggests that most investors do not rebalance their portfolios—that is, buying assets that have become cheap and selling assets that have become expensive. In fact, many investors do the exact opposite!
Why is it so hard for investors to rebalance? The answer is less about “behavioral mistakes” and more about the fact that “rational” individuals care more about other things than simply maximizing investment returns. Perfectly rational individuals exhibit changing risk aversion that makes it hard for them to rebalance into high return assets, which have suffered steep recent price declines. The unwillingness to buy low and sell high is not characteristic of just retail investors, who are unaware of the finance literature and market history. Very sophisticated institutional investors, advised by investment consultants and academics, are prone to the very same behavior.1
This issue of Fundamentals reviews the empirical evidence for return improvement from rebalancing, as well as the reasons why most sensible investors don’t do it.
A significant body of financial research has shown that asset classes exhibit long-horizon price mean-reversion.2 When an asset class falls in price, resulting in a more attractive valuation level relative to history, it is more likely to experience high subsequent returns. For example, when the S&P 500 Index falls in price, its dividend yield increases; empirically the subsequent five-year return on the S&P 500 tends to be significantly above average.3 Similarly, when corporate bond prices fall as credit spreads blow out, the forward return on corporate bonds increases.4 Price mean-reversion in asset returns suggests that a disciplined rebalancing approach in asset allocation that responds to changing valuation levels would improve portfolio returns in the long-run.5
So, if “buy low and sell high” works so well, why don’t investors rebalance? Research suggests that our risk attitude interacts in a predictable way with our wealth level and thereby influences our decision-making with respect to rebalancing. Specifically, investors tend to become more risk averse and, therefore, unwilling to add risk to their portfolios despite lower prices when their portfolio wealth declines. Investors tend to become more risk seeking and, therefore, more willing to speculate even at high prices when their portfolio wealth increases.6
The following illustration provides an intuitive way to understand this behavior. Consider a household with a certain level of income and wealth. This household anchors its standard of living (expenditure pattern) to its income/wealth profile. When positive fundamental shocks (such as a surprise jump in GDP or corporate earnings growth) hit the market, stock prices go up. A string of positive economic surprises, and the resulting equity bull market, can lead to a substantial increase in investor wealth. This market environment is also generally characterized by low unemployment, strong wage increases, healthy bonuses, and appreciation in real estate value.
The investment gain coupled with stronger income affords the household the “option” to take an extra vacation, upgrade to a larger house and/or retire earlier. The higher household income and the substantial increase in wealth also allow the household to take on more risk without affecting its standard of living and retirement prospects. The investor compartmentalizes the newfound wealth as a “windfall”—analogous to “house money” from casino winnings. Often, the investor speculates with this windfall; this is not dissimilar to the increase in aggressive betting when a gambler has just won big and is playing with “the house’s” money. The house money effect can explain why investors do not rebalance away from equities after a major rally, even though higher prices significantly reduce expected forward returns.