I’ve written a number of articles on the benefits of rebalancing. So it was interesting to read Research Affiliates’ CIO On “Why We Don’t Rebalance” which reads in part:

The reason it’s so hard for investors to rebalance, says Hsu, 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 that have had steep price declines,” he says. “An unwillingness to buy low and sell high is not characteristic of just retail investors unaware of the finance literature and market history, but also sophisticated institutional investors advised by investment consultants and academics who are also prone to the same behavior.”

Hsu says financial research shows that asset classes exhibit long-horizon price mean-reversion. So when an asset class falls in price, resulting in a more attractive valuation level relative to history, it’s 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.

… 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.

In other words, investors changing risk preferences make it so that they want to take risks when they shouldn’t, and they don’t want to take risks when they should. Even professionals in the industry suffer from the same emotions and have to overcome these feelings in order to follow a disciplined approach to asset allocation and improve portfolio returns.

The article continues:

So, if “buy low and sell high” works so well, why don’t investors rebalance? Hsu asks. He says research suggests that investors become more risk averse and 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.

If the $1 million question is “Why don’t investors rebalance?” Hsu adds, then the $5 million question is “Should you rebalance?” Statistically, he says you’re likely to outperform in the long run if you rebalance in response to major price movements. However, when you buy risky assets during economic distress, Hsu says, there’s a strong chance your portfolio may post a greater decline than if you didn’t rebalance. “In the short run, your probability of being fired as a fiduciary, of being blamed by clients you advise, and, most importantly, of marital strife, become moderately higher when you rebalance,” Hsu says

In spite of the benefits of rebalancing, humans’ changing risk aversion makes them poor stewards for managing long-term returns, he concludes.

We risk going against our clients changing risk aversion and recommend putting money into asset classes that have dropped and recommend taking money out of asset classes that have gone up. I’ve seen too many client bail at the bottom and go all in at the top against better judgement. Normal market volatility should not be allowed to spoil a brilliant asset allocation. Neither should changing risk aversion be allowed to cause you to miss a rebalancing bonus as markets revert to the mean.

Yes, yes, I understand the feeling that this time it is different. It always feels different. But that’s what makes us poor stewards for managing long-term returns.