In Part 3, portfolio rebalancing was discussed as a method of keeping a portfolio’s risk stable – and presumably matched to an investor’s stable tolerance of risk. For example, an investor targeting a moderate level of risk might rebalance the equity exposure of a portfolio based on how much the market has moved. The portfolio might be rebalanced back towards a target equity risk exposure of, say, 55%. Whenever equities have risen causing the percentage of the portfolio in equities to reach a high level of 60%, rebalancing would require selling equities (and buying bonds). Conversely, in a bear market the equity percentage might fall to 50% and trigger rebalancing by purchasing equities (and selling bonds). Some investors might rebalance periodically such as quarterly regardless of market movements.
In any case, portfolio balancing should be viewed as a price-reverting strategy. An equity investor with a price reverting strategy buys equities after equity prices decline and sells equities after equity prices rise. Whether it is their intention or not, the act of investors rebalancing their portfolios to target levels will cause long-term performance to be higher when markets prices revert and lower when market prices trend.
It would seem that a strategy of keeping equity risk exposures near to their targets would not be a strategy of market timing. But this apparently conservative strategy can be viewed as a speculation on whether market prices trend or revert. The frequency with which the investor rebalances determines the time horizon over which the reversion or trending matters. Part 1 of this series set forth the idea that any tendency of a market to revert or trend must be related to the typical time horizon at which rebalancing takes place – such as daily, monthly or annual.
For example, the performance of a portfolio that is rebalanced quarterly will be driven by whether quarterly equity prices reverted or trended. So the decision to rebalance a portfolio with a particular frequency is not just a bet on price reversion – it is a bet based on the nature of equity returns for the time interval selected for rebalancing.
It is important to note that equity markets may experience only random price movements; meaning that prices in one period have no consistent tendency to go up or down based on what happened in the previous period. But even if prices are completely random, over finite periods of time that randomness will still generate periods of time when prices happened to revert more often than trend, or vice versa. Just like a random slot machine has periods of high payouts and periods of low payouts, even a stock market with random price changes will experience periods in which portfolios that are rebalanced do well, and periods in which portfolios that rebalanced do poorly. Specifically, rebalanced portfolios will do better in mean-reverting (zig-zag) markets and will do worse than buy-and-hold strategies in trending equity markets.