Optimal rebalancing strategies reduce market variability

Abstract

The increasing fraction of passive funds influences stock market variability since passive investors behave differently than active investors. We demonstrate via simulations how portfolios that rebalance between different classes of assets influence the market variability. We prove that the optimal strategy for such portfolios when we include transaction costs, is only to rebalance when the portfolio leaves a no-trade region in the state space. This is the case also when the expectation and volatility of the prices are inhomogeneous. We show that portfolios that apply an optimal rebalance strategy reduce the variability in the stock market measured in the sum of the distances between local minimum and maximum of the prices in the stock market, also when these portfolios constitute only a small part of the market. However, the more usual rebalance strategies that only consider to rebalance at the end of a month or a quarter, have a much weaker influence on the market variability.