Can rebalancing unintentionally raise a portfolio’s volatility risk?

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Kinetic Currency
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Can rebalancing unintentionally raise a portfolio’s volatility risk?

Post by Kinetic Currency »

I’m a long-time BH lurker and owe a great deal of gratitude to this forum. My investing journey has brought me to a theoretical conundrum that I am trying to resolve.
Traditional wisdom advocates that investors set portfolio allocations to match their “risk tolerance.” Once the portfolio is set, the recipe calls for the maintenance of target allocations by “periodically” rebalancing.
In theory, rebalancing allows one the opportunity to sell high and buy low. However, the part I’m struggling with is the assertion that rebalancing returns the portfolio to its target risk level. I’m beginning to wonder if rebalancing might actually INCREASE a portfolio’s risk level during down markets.
Let’s assume we’re starting with a portfolio that’s 50% cash and 50% S&P 500 index fund. At the start, there is a theoretical portfolio volatility (risk level) of 50% cash and 50% the S&P’s historical volatility or implied volatility (VIX), whichever you like.
Whenever the stock market suddenly declines, its volatility rises. At the portfolio level, the proportion of stocks relative to cash must correspondingly decline. So in proportional terms, you end up holding more of the less volatile asset (cash) and less of the more volatile asset (stocks). In other words, by doing nothing, the portfolio self-adjusts for risk. By rebalancing when the VIX is up, one is actually increasing the portfolios’s volatility exposure, albeit for the opportunity to buy low.
From a practical standpoint, the reason I’m raising this question is to determine whether I should accept a higher additional risk burden when rebalancing during down markets or whether I should pursue a more explicit targeted portfolio volatility level. The outcomes may ultimately reflect a match up between buy the dip investing vs momentum harvesting.
Last edited by Kinetic Currency on Wed Aug 17, 2022 2:51 pm, edited 1 time in total.
alluringreality
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Re: Can rebalancing unintentionally raise a portfolio’s volatility risk?

Post by alluringreality »

Kinetic Currency wrote: Mon Aug 15, 2022 6:19 am I’m beginning to wonder if rebalancing might actually INCREASE a portfolio’s risk level during down markets.
As stocks fall in price, a constant-mix strategy tends to place more of the initial portfolio into stocks. This behavior is displayed with Table 2 and Figure 6 in the following. Generally someone following a constant-mix strategy benefits if falling stock price reverses back to the initial price. This situation could probably be interpreted as taking more risk than buy and hold during a stock price decline.
https://www.semanticscholar.org/paper/D ... 76a5174cca
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Florida Orange
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Re: Can rebalancing unintentionally raise a portfolio’s volatility risk?

Post by Florida Orange »

I have always felt the same way. By rebalancing from cash (or bonds) into stocks when stocks are down you are taking on more risk. You do it for the opportunity to "buy stocks cheap". This action is predicated on your belief that stocks will recover before your portfolio is depleted. For true risk minimization you would do one-way rebalancing where you rebalance from stocks to cash (or bonds) when the stock portion of your portfolio becomes too high, but not the other way. You probably forego some long term gains by not buying stocks when they are "on sale", but it does decrease the overall risk to the portfolio. I think of it as the price you pay for safety.
Nowizard
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Re: Can rebalancing unintentionally raise a portfolio’s volatility risk?

Post by Nowizard »

Definitely more risk in my opinion, but the focus is not on present risk but longer term appreciation based on the depreciating assets at lower cost. The psychological issue is more where your focus is, short or long term, and your post focuses on the risk side more than the potential appreciation aspect. The trade-off is the old adage that greater possibility of appreciation comes with greater risk.

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firebirdparts
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Re: Can rebalancing unintentionally raise a portfolio’s volatility risk?

Post by firebirdparts »

I'm going to call this a good problem to have and just happily accept it. In fact, I'm enthusiastic about it.

We have argued about whether or not it makes sense to wait 3 months or 6 months vs. rebalancing every day. To me, quarterly is pretty fast.
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Logan Roy
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Re: Can rebalancing unintentionally raise a portfolio’s volatility risk?

Post by Logan Roy »

Kinetic Currency wrote: Mon Aug 15, 2022 6:19 am Whenever the stock market suddenly declines, its volatility rises. At the portfolio level, the proportion of stocks relative to cash must correspondingly decline. So in proportional terms, you end up holding more of the less volatile asset (cash) and less of the more volatile asset (stocks). In other words, by doing nothing, the portfolio self-adjusts for risk. By rebalancing when the VIX is up, one is actually increasing the portfolios’s volatility exposure, albeit for the opportunity to buy low.
From a practical standpoint, the reason I’m raising this question is to determine whether I should accept a higher additional risk burden when rebalancing during down markets or whether I should stick to a more explicit targeted portfolio volatility level. The outcomes may ultimately reflect a match up between buy the dip investing vs momentum harvesting.
Yes, I think you're right. And that's why I think it can be a fun, relatively harmless form of market timing to 'time' your rebalances. But this concern is only justified if we accept that there are effects like momentum.

If we take the view that the market is a random walk, then rebalancing often makes sense. If we accept that our attempts at timing are no better than chance, then it also makes sense. In backtests, a single annual rebalance often produces about the best results, as it gives momentum a bit of space to play out (on the up and downside – e.g. allowing a gold allocation to swell, and become a larger hedge, as demand increases).

It's just really whether it's rational to believe we can do better. I would say an annual rebalance probably makes most sense, as momentum is typically a 6-12 month phenomenon. If we were going to stay defensive for several years, as a bear market deepens, we do run into the problem of not having our usual market exposure when the market suddenly bounces back, and we often get these very large returns near the bottom. Trying to catch them is also a problem, as bear markets are characterised by false starts. So it's: can we do better? I think if you really follow trends and macro, daily, you can probably do a pretty good job steering your own ship.
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windaar
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Re: Can rebalancing unintentionally raise a portfolio’s volatility risk?

Post by windaar »

For me rebalancing has always been a once-a-year task to keep me within my AA, not a tactical thing to buy low or whatever. Many here do bands and that’s great for them but to me that defeats the point of “set, forget, and don’t try to outsmart the market.”
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Logan Roy
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Re: Can rebalancing unintentionally raise a portfolio’s volatility risk?

Post by Logan Roy »

I'd admit my portfolio looks quite different now to how it did through much of the bull market. I used to maintain 25% in All Weather. Now I'm almost entirely All Weather. I wouldn't call it timing – prospects for bonds have been terrible for years; for stocks, it really hinges on inflation. This, compared to a decade in which any economic weakness would be met with stimulus. I think there's a time to put the pedal to the metal, and a time to coast.
Last edited by Logan Roy on Mon Aug 15, 2022 10:20 am, edited 1 time in total.
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SimpleGift
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Re: Can rebalancing unintentionally raise a portfolio’s volatility risk?

Post by SimpleGift »

Kinetic Currency wrote: Mon Aug 15, 2022 6:19 am The outcomes may ultimately reflect a match up between buy the dip investing vs momentum harvesting.
When in the accumulation stage, with ample human capital left in one's employability, and more ability to take on risk, the "buy-the-dip" mentality is likely to be the best long-term approach.

However in retirement, with little human capital remaining, many investors adopt a one-way rebalancing strategy — i.e., rebalancing from stocks into bonds, but not rebalancing from bonds into stocks during crashes and sell-offs.

At least this has been the reported experience of quite a few Bogleheads posting here on the Forum.
dbr
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Re: Can rebalancing unintentionally raise a portfolio’s volatility risk?

Post by dbr »

Obviously if stocks go down and you bring up the stock allocation by rebalancing then the risk is restored to a higher value than it would have if one left the stock allocation low. That is intended as the idea is not to limit risk but to set risk and set return, the one trading off against the other. The idea that stocks are more volatile when they have declined and the implications of that would need a lot more analysis. Naive rebalancing rules assume that expected risk and expected return do not vary systematically with rises and falls in some way that can be addressed by a more complicated algorithm.'

It is true that not rebalancing into stock declines but rebalancing into stock gains is a possible strategy. It is highly debatable if this works better than just rebalancing an asset allocation with less in stocks in the first place as the two probably have a similar effect.
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SimpleGift
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Re: Can rebalancing unintentionally raise a portfolio’s volatility risk?

Post by SimpleGift »

dbr wrote: Mon Aug 15, 2022 10:29 amIt is true that not rebalancing into stock declines but rebalancing into stock gains is a possible strategy. It is highly debatable if this works better than just rebalancing an asset allocation with less in stocks in the first place as the two probably have a similar effect.
Speaking personally, the nagging fear in retirement, when one's human capital is mostly exhausted, is that the stock market may go down and not recover for years and years. So not rebalancing from bonds into stocks during market declines is a way of not risking what one can't afford to permanently lose. A psychological crutch perhaps.

This became clear for a lot of retirees during the 2008 Financial Crisis, I believe, when the fate of the global financial system was highly uncertain and seemingly hung in the balance. We never appreciated having a big stash of safe Treasury bonds so much in our entire lives!

At the same time, we've been able to take advantage of stock market gains, by rebalancing back into bonds when fortune happens to smile.
Last edited by SimpleGift on Mon Aug 15, 2022 2:36 pm, edited 1 time in total.
Apathizer
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Re: Can rebalancing unintentionally raise a portfolio’s volatility risk?

Post by Apathizer »

firebirdparts wrote: Mon Aug 15, 2022 8:28 am I'm going to call this a good problem to have and just happily accept it. In fact, I'm enthusiastic about it.

We have argued about whether or not it makes sense to wait 3 months or 6 months vs. rebalancing every day. To me, quarterly is pretty fast.
Yeah, quarterly or even semiannually seems about right to me. Even annually is probably fine. More often than that seems a little OCD to me.
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carminered2019
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Re: Can rebalancing unintentionally raise a portfolio’s volatility risk?

Post by carminered2019 »

I don't' know if it more risk or not but I was 70/30, down to negative 900K+ couple months then rebalanced to 87/13 and now back to only down negative 300K from all time high. My goal is to beat 70/30.
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Re: Can rebalancing unintentionally raise a portfolio’s volatility risk?

Post by Hydromod »

Another way to look at it is to set a risk budget allocation and maintain the assets accordingly. The risk budget is the fraction of portfolio volatility that stems from each asset. So when stocks are especially volatile, bonds have a heavier weight, and vice versa.

The overall effect is to reduce portfolio volatility, and perhaps boost returns a little.

That type of risk management tends to be more important with leveraged assets.
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arcticpineapplecorp.
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Re: Can rebalancing unintentionally raise a portfolio’s volatility risk?

Post by arcticpineapplecorp. »

Kinetic Currency wrote: Mon Aug 15, 2022 6:19 am From a practical standpoint, the reason I’m raising this question is to determine whether I should accept a higher additional risk burden when rebalancing during down markets or whether I should stick to a more explicit targeted portfolio volatility level.
the risk was always there regardless of the current volatility.

saying you're going to accept higher additional risk burden by buying stocks when they've fallen below 50% in your example doesn't change the fact that stocks were risky all the time, regardless of whether you're holding 30% or 50%. They were risky when you held 50% stocks. Just because it's fallen to 30% doesn't mean you have less risk. Yes, the portfolio overall is less risky. Yes, when stocks fall, the risk has already shown up so theoreticallly there's less risk (doesn't mean stocks can't continue to fall). But stocks are more risky at the top of the bull market than at the bottom of the bear market.

a wise boglehead once wrote something to the effect of when stocks go up people focus on opportunity and ignore risk and when stocks go down people focus on risk but ignore opportunity.

if you want to be 50/50 then you should rebalance back to that by buying stocks when they dip below your predetermined rebalancing band. To do otherwise is to allow your portfolio to hold different levels of risk at different times. I understand what you're trying to do, but isn't it more sensible to systematically reduce risk during a bull market, then accept the market will reduce your risk for you in a bear market?

besides, is volatility measured in only one direction (down)? Can't prices move up as much as they move down? Why is that not a similar concern with regards to risk and allocation?
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Re: Can rebalancing unintentionally raise a portfolio’s volatility risk?

Post by vineviz »

Kinetic Currency wrote: Mon Aug 15, 2022 6:19 am I’m beginning to wonder if rebalancing might actually INCREASE a portfolio’s risk level during down markets.
Price volatility is not a serious risk for long-term investors.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch
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Re: Can rebalancing unintentionally raise a portfolio’s volatility risk?

Post by Hyperchicken »

Seems like extremely twisted logic here.

Let's say I want a 60/40 portfolio, so this is the AA that I maintain.

Then let's say stock market goes down, and I end up with 55/45, which I then rebalance back to 60/40.

Sure 60/40 is more volatile than 55/45, but that's where I wanted to be in the first place.
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Kinetic Currency
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Re: Can rebalancing unintentionally raise a portfolio’s volatility risk?

Post by Kinetic Currency »

I appreciate all the responses and have taken a minute to process them all. While on the surface there is some disagreement over this issue, it seems to me that there is a lot more consensus that I can incorporate as I formulate a personal decision tree. The consensus revolves around time. Whether you look at the Sharpe ratio or the one-directional Sortino ratio, risk is traditionally associated with volatility. As Vineviz wrote, none of that matters if you’re running an endowment or a life insurance company. But to a retiree, as SimpleGift pointed out, one cannot afford to tolerate excessive volatility. And while I realize we have been discussing stocks, this past year I witnessed a 20% drop in my long term treasuries. Fortunately, I’m still in the accumulation phase and I know they will recover. But what if I were in retirement and needed to live off of what I had been taught were “safe” bonds while the stock market was also down? Sure bonds will almost certainly recover as they approach their duration/maturity. But in the moment, as you’re withdrawing to pay off living expenses, you can’t possibly feel safe. That’s what led me down this road of examining volatility risk. This discussion helped me realize that I need to factor in my personal “duration risk” when implementing a rebalancing strategy.
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Re: Can rebalancing unintentionally raise a portfolio’s volatility risk?

Post by vineviz »

Kinetic Currency wrote: Tue Aug 16, 2022 4:56 am As Vineviz wrote, none of that matters if you’re running an endowment or a life insurance company.
It doesn’t matter to an investor with a 20-30 year retirement either.

At least, not objectively.

Too many retirees mislead themselves (or are misled) into behaving like short-term investors when they aren’t.
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Florida Orange
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Re: Can rebalancing unintentionally raise a portfolio’s volatility risk?

Post by Florida Orange »

I think short term thinking is why so many people use the phrase "bull market in bonds" in a declining interest rate environment. For most most bond investors, and for all long term bond investors, low or declining interest rates are not good.
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Re: Can rebalancing unintentionally raise a portfolio’s volatility risk?

Post by Apathizer »

This informative article discusses re-balancing in detail. It does seems to reduce volatility over a buy and hold approach. As long as it's done regularly, frequency doesn't seem to matter much. Overall volatility is similar for annual re-balancing compared to more frequently.
https://www.morningstar.com/articles/11 ... rs-in-2022
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Kinetic Currency
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Re: Can rebalancing unintentionally raise a portfolio’s volatility risk?

Post by Kinetic Currency »

Thank you for sharing this timely article. It demonstrates how buy-and-hold was inferior to periodically rebalanced portfolios for this past year, with respect to returns.
As the author wrote “The reason for these results is straightforward: Thanks to generally strong equity market returns, the buy-and-hold portfolio would have had more and more equity exposure over time. By the end of 2021, the portfolio's stock position would have climbed to more than 74% of assets. That left it more exposed to the downdraft in the first six months of 2022.” I’m interpreting that to mean that rebalancing from stocks to bonds (during calm markets near ATH’s), which others have suggested during this conversation, is what contributed to the improved returns. As Arcticpineapplecorp explained, there is higher potential risk at ATH’s, despite the low immediate volatility (calm before the storm).
I get that, but my question has to do with rebalancing in the midst of the storm. Yes there’s the expectation that higher risk leads to higher rewards, but not always. For example international funds have had relatively higher volatility compared to U.S. markets but worse returns in the recent past. At ATH’s we know the actual gains and potential risk. At market bottoms we know the actual risk and potential gains. This reminds me of the idiom, “A Bird in the Hand is Worth Two in the Bush.”
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Kinetic Currency
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Re: Can rebalancing unintentionally raise a portfolio’s volatility risk?

Post by Kinetic Currency »

A classic article that nicely explores the main points of this discussion by William Sharpe himself. Thanks for sharing.
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