The Rebalancing Premium

Holding a fixed target allocation — say, 50/50 between two assets — and periodically trading back to those weights forces a mechanical discipline: whichever asset outperformed since the last rebalance gets trimmed, and whichever underperformed gets topped up, regardless of any view on which will do better going forward. This systematic sell-high, buy-low behavior can produce a return premium over a static buy-and-hold portfolio, purely as a mathematical consequence of periodically resetting weights on volatile, imperfectly correlated assets — it requires no forecasting skill.

A simple illustration: two assets both start at $100 and both end back at $100 after one year, but one doubled to $200 at midyear before falling back, while the other stayed roughly flat. A buy-and-hold 50/50 portfolio just returns to its starting value with no gain. A portfolio rebalanced at midyear would have trimmed the doubled asset (locking in some of its gain) and added to the flat one, ending with more total value than the buy-and-hold version, since it captured some of the round trip instead of watching it fully unwind.

The size of this premium grows with both assets' volatility and shrinks as their correlation rises — near-perfectly-correlated assets offer almost no rebalancing benefit, since there's rarely a large relative swing to trade against.