Hobby Stocks and Rebalancing
Moderator: hocus2004
Hobby Stocks and Rebalancing
As I look at the data, I keep coming back to this question: Is rebalancing portfolio allocations a good idea? More and more, the data have been telling me NO!, except under the most stressful conditions. Rebalancing takes far more away from the upside than it gives back in the way of downside protection.
Right now, today, rebalancing is a good idea. These are stressful times. Stock valuations remain in bubble territory. Interest rates are low.
All of this will change. When stock valuations fall down to reasonable levels, even if they remain high, rebalancing will become a bad idea once again.
Those are the conclusions that I draw from my most recent survey using my most recent calculators. I examined whether one should rebalance hobby stocks with his core holdings or whether he should allow them to grow unimpeded.
Most of the time, my answer is: Let them grow.
The Portfolios
Portfolio A was entirely in stocks as represented by the S&P500 index. This corresponds to the hobby stock portion of one's portfolio.
Portfolio B consisted of 50% stocks and 50% Treasury Bills. It was rebalanced annually. This was the core holding.
The Conditions
I started with an initial balance of $100000. I set the investment expenses at 0.20%.
I allocated 20% of the initial balance to Portfolio A and 80% to Portfolio B.
I withdrew 3%, 4% and 5% of the initial balance (plus inflation) from the individual portfolios in proportion to their balances.
I recorded balances of the combined portfolio at year 30 when I rebalanced Portfolios A and B and when I let them grow separately.
Calculator Conditions
I used the Gummy 04 version of the Deluxe Calculator V1.1A08 dated January 28, 2005. This calculator includes a complete set of Gummy's data, which can be entered separately as if they were stocks and commercial paper.
Portfolio A appears as stock holdings and Portfolio B appears as if it were commercial paper.
Here are the key entries:
Portfolio A: Entered as stocks
Portfolio B: Entered as commercial paper
Portfolio A: 100% S&P500 stocks
Portfolio B: 50% S&P500 stocks and 50% T-Bills
Stock allocation: 20%
Fixed Income Series: commercial paper
Front end/back end?: 50%
Inflation: CPI
Investment expenses: 0.20%
Rebalance? NO!, the basic condition, and YES for making comparisons.
Others: Gummy's Algorithms 1 and 2: NO. Remove gains? NO.
Others: Reinvest Dividends? Yes, 100%. Reinvest Interest? Yes, 100%.
The calculator automatically rebalances the holdings within a portfolio. It offers a choice as to whether to rebalance between the two portfolios.
I examined 30-year historical sequences starting in 1921-1980. Gummy's data are for the years 1928-2000. I used Professor Shiller's S&P500 stock data prior to 1928. I used the stock returns of 2000 for the years 2001-2010. Be cautious about any conclusions based on sequences starting in years 1921-1927 and ending in 2001-2010. (Those 30-year sequences start in 1971-1980.)
Dollar Allocations
I set the initial balance equal to $100000.
I allocated 20% of this initial balance to portfolio A. This is $20000 in the S&P500 index.
I allocated 80% of this initial balance to portfolio B. This is $80000. It is divided equally between the S&P500 index and Treasury Bills.
Portfolio B started with $40000 in the S&P500 index and $40000 in Treasury Bills.
The combination of the two portfolios started out with $60000 in the S&P500 index and $40000 in Treasury Bills.
Tables
I am including tables of the balances at year 30 with withdrawal rates of 3%, 4% and 5% of the initial balance (plus inflation). All balances are in terms of real dollars. That is, after adjusting for inflation.
I have one table in which portfolios A and B are allowed to grow separately. I have another table in which the 20% / 80% allocation of portfolios A and B are maintained through annual rebalancing.
I have a third table in which I present the differences of the balances with and without rebalancing. Positive numbers indicate a rebalancing bonus. Negative numbers indicate a rebalancing penalty.
[In making these calculations, I substituted zero for any negative balance. This prevents any big losses from distorting the results.]
The fourth table has a 1 whenever the money ran out by year 30 with rebalancing. The fifth table has a 1 whenever the money ran out by year 30 without rebalancing.
[These two tables turn out to be identical except for one condition. It is the 1940 historical sequence with a 5% withdrawal rate. The 1940 portfolio with rebalancing would have run out of money by year 30. Without rebalancing, the 1940 portfolio would have lasted for the full 30 years.]
Analysis
Only a few conditions show a rebalancing bonus. Those with a bonus show only a small improvement. The sequences with a rebalancing bonus are those associated with high valuations and times of severe portfolio stress: a few years around 1929 and the entire decade of the 1960s.
Typically, there was a penalty for rebalancing. Typically, it was huge.
Conclusions
Except in times of severe portfolio stress, one is better off letting his hobby stocks grow unimpeded.
This happens to be a time of severe portfolio stress. Today's valuations are higher than during the Great Depression and during the 1960s (and stagflation).
Have fun.
John R.
Right now, today, rebalancing is a good idea. These are stressful times. Stock valuations remain in bubble territory. Interest rates are low.
All of this will change. When stock valuations fall down to reasonable levels, even if they remain high, rebalancing will become a bad idea once again.
Those are the conclusions that I draw from my most recent survey using my most recent calculators. I examined whether one should rebalance hobby stocks with his core holdings or whether he should allow them to grow unimpeded.
Most of the time, my answer is: Let them grow.
The Portfolios
Portfolio A was entirely in stocks as represented by the S&P500 index. This corresponds to the hobby stock portion of one's portfolio.
Portfolio B consisted of 50% stocks and 50% Treasury Bills. It was rebalanced annually. This was the core holding.
The Conditions
I started with an initial balance of $100000. I set the investment expenses at 0.20%.
I allocated 20% of the initial balance to Portfolio A and 80% to Portfolio B.
I withdrew 3%, 4% and 5% of the initial balance (plus inflation) from the individual portfolios in proportion to their balances.
I recorded balances of the combined portfolio at year 30 when I rebalanced Portfolios A and B and when I let them grow separately.
Calculator Conditions
I used the Gummy 04 version of the Deluxe Calculator V1.1A08 dated January 28, 2005. This calculator includes a complete set of Gummy's data, which can be entered separately as if they were stocks and commercial paper.
Portfolio A appears as stock holdings and Portfolio B appears as if it were commercial paper.
Here are the key entries:
Portfolio A: Entered as stocks
Portfolio B: Entered as commercial paper
Portfolio A: 100% S&P500 stocks
Portfolio B: 50% S&P500 stocks and 50% T-Bills
Stock allocation: 20%
Fixed Income Series: commercial paper
Front end/back end?: 50%
Inflation: CPI
Investment expenses: 0.20%
Rebalance? NO!, the basic condition, and YES for making comparisons.
Others: Gummy's Algorithms 1 and 2: NO. Remove gains? NO.
Others: Reinvest Dividends? Yes, 100%. Reinvest Interest? Yes, 100%.
The calculator automatically rebalances the holdings within a portfolio. It offers a choice as to whether to rebalance between the two portfolios.
I examined 30-year historical sequences starting in 1921-1980. Gummy's data are for the years 1928-2000. I used Professor Shiller's S&P500 stock data prior to 1928. I used the stock returns of 2000 for the years 2001-2010. Be cautious about any conclusions based on sequences starting in years 1921-1927 and ending in 2001-2010. (Those 30-year sequences start in 1971-1980.)
Dollar Allocations
I set the initial balance equal to $100000.
I allocated 20% of this initial balance to portfolio A. This is $20000 in the S&P500 index.
I allocated 80% of this initial balance to portfolio B. This is $80000. It is divided equally between the S&P500 index and Treasury Bills.
Portfolio B started with $40000 in the S&P500 index and $40000 in Treasury Bills.
The combination of the two portfolios started out with $60000 in the S&P500 index and $40000 in Treasury Bills.
Tables
I am including tables of the balances at year 30 with withdrawal rates of 3%, 4% and 5% of the initial balance (plus inflation). All balances are in terms of real dollars. That is, after adjusting for inflation.
I have one table in which portfolios A and B are allowed to grow separately. I have another table in which the 20% / 80% allocation of portfolios A and B are maintained through annual rebalancing.
I have a third table in which I present the differences of the balances with and without rebalancing. Positive numbers indicate a rebalancing bonus. Negative numbers indicate a rebalancing penalty.
[In making these calculations, I substituted zero for any negative balance. This prevents any big losses from distorting the results.]
The fourth table has a 1 whenever the money ran out by year 30 with rebalancing. The fifth table has a 1 whenever the money ran out by year 30 without rebalancing.
[These two tables turn out to be identical except for one condition. It is the 1940 historical sequence with a 5% withdrawal rate. The 1940 portfolio with rebalancing would have run out of money by year 30. Without rebalancing, the 1940 portfolio would have lasted for the full 30 years.]
Analysis
Only a few conditions show a rebalancing bonus. Those with a bonus show only a small improvement. The sequences with a rebalancing bonus are those associated with high valuations and times of severe portfolio stress: a few years around 1929 and the entire decade of the 1960s.
Typically, there was a penalty for rebalancing. Typically, it was huge.
Conclusions
Except in times of severe portfolio stress, one is better off letting his hobby stocks grow unimpeded.
This happens to be a time of severe portfolio stress. Today's valuations are higher than during the Great Depression and during the 1960s (and stagflation).
Have fun.
John R.
Without rebalancing Portfolios A and B
Year, Real Balances at year 30 for withdrawal rates of 3%, 4% and 5%
More follows.
John R.
Year, Real Balances at year 30 for withdrawal rates of 3%, 4% and 5%
Code: Select all
1921 220593 157638 94682
1922 205387 145021 84656
1923 194709 133620 72532
1924 189150 130054 70958
1925 229980 156474 82968
1926 242309 154433 66558
1927 220587 136735 52882
1928 154644 85425 16207
1929 104222 21875 (60928)
1930 115923 22254 (72007)
1931 155226 59363 (36675)
1932 356755 239613 122471
1933 355752 264195 172639
1934 244991 148984 52978
1935 309518 205191 100864
1936 196049 93041 (9979)
1937 109079 20171 (69441)
1938 273410 168593 63776
1939 188875 87077 (14751)
1940 184096 98141 12186
1941 255004 179831 104657
1942 393582 313295 233007
1943 400798 314899 229000
1944 273669 207297 140925
1945 176510 129986 83462
1946 172301 126888 81475
1947 277082 225192 173301
1948 271019 223389 175759
1949 258912 213974 169036
1950 230362 191613 152865
1951 219235 177129 135022
1952 174265 135618 96971
1953 169468 128136 86804
1954 199800 154556 109312
1955 125581 81399 37216
1956 107537 58375 9213
1957 121727 68705 15682
1958 154047 101109 48172
1959 102736 47799 (7144)
1960 105696 43997 (17744)
1961 105673 48097 (9491)
1962 85823 20570 (44955)
1963 112430 47334 (17806)
1964 84861 18686 (47814)
1965 65124 1935 (61812)
1966 68512 (5443) (80204)
1967 112703 30922 (51199)
1968 112791 14966 (82897)
1969 117327 10653 (97009)
1970 188101 69757 (48877)
1971 182515 74733 (33216)
1972 166125 65993 (34125)
1973 143476 58712 (26064)
1974 195806 123071 50336
1975 302578 234061 165545
1976 217995 157143 96292
1977 176900 123627 70355
1978 206505 160015 113525
1979 212856 173300 133743
1980 200159 164483 128808
John R.
With rebalancing of Portfolios A and B
Year, Real Balances at year 30 for withdrawal rates of 3%, 4% and 5%
The next table shows the rebalancing bonuses.
Have fun.
John R.
Year, Real Balances at year 30 for withdrawal rates of 3%, 4% and 5%
Code: Select all
1921 187744 131037 74330
1922 172249 118777 65305
1923 171252 116293 61334
1924 167130 113552 59973
1925 205778 140009 74241
1926 221687 142702 63717
1927 204601 128595 52589
1928 153325 86686 20047
1929 104098 24737 (55009)
1930 113555 25038 (63967)
1931 144617 56664 (31420)
1932 281670 184303 86937
1933 281471 204355 127239
1934 200404 117975 35546
1935 248022 159917 71812
1936 163428 73784 (15896)
1937 95793 14423 (67623)
1938 215701 126085 36469
1939 152465 63507 (25546)
1940 152263 75222 (1819)
1941 210471 143276 76080
1942 315750 245361 174971
1943 324062 248669 173276
1944 235806 174244 112682
1945 162613 116798 70983
1946 160539 116116 71694
1947 252910 202934 152958
1948 251855 205150 158444
1949 241604 197301 152998
1950 217174 178912 140650
1951 208529 167094 125659
1952 170465 131697 92929
1953 166633 125255 83877
1954 194756 149724 104691
1955 125292 80999 36706
1956 108021 58891 9761
1957 122085 69266 16448
1958 152690 100119 47547
1959 103274 48543 (6192)
1960 106125 44928 (16304)
1961 106411 49081 (8258)
1962 86916 22015 (43138)
1963 112513 48131 (16290)
1964 85655 20014 (45928)
1965 66298 3333 (60164)
1966 69521 (3793) (77881)
1967 111769 31858 (48362)
1968 111713 16383 (78982)
1969 115254 12138 (91894)
1970 179591 67675 (44491)
1971 176050 72902 (30387)
1972 163196 65675 (31831)
1973 143224 59304 (24627)
1974 193658 121803 49948
1975 291172 223882 156591
1976 214773 153982 93191
1977 176614 122891 69167
1978 206183 159101 112019
1979 213577 173329 133082
1980 201828 165439 129050
Have fun.
John R.
Rebalancing bonus (penalty).
Year, Differences in the real balances at year 30 for withdrawal rates of 3%, 4% and 5%
There are not many bonuses. There are lots of big penalties.
Have fun.
John R.
Year, Differences in the real balances at year 30 for withdrawal rates of 3%, 4% and 5%
Code: Select all
1921 (32849) (26600) (20352)
1922 (33138) (26245) (19351)
1923 (23457) (17327) (11198)
1924 (22019) (16502) (10985)
1925 (24203) (16465) (8727)
1926 (20622) (11731) (2841)
1927 (15986) (8140) (293)
1928 (1319) 1260 3840
1929 (123) 2863 0
1930 (2367) 2785 0
1931 (10608) (2699) 0
1932 (75085) (55309) (35534)
1933 (74281) (59840) (45399)
1934 (44587) (31009) (17432)
1935 (61496) (45274) (29052)
1936 (32621) (19257) 0
1937 (13286) (5748) 0
1938 (57709) (42508) (27307)
1939 (36410) (23570) 0
1940 (31833) (22919) (12186)
1941 (44533) (36555) (28577)
1942 (77832) (67934) (58036)
1943 (76736) (66230) (55724)
1944 (37863) (33053) (28243)
1945 (13897) (13188) (12478)
1946 (11763) (10772) (9781)
1947 (24172) (22257) (20343)
1948 (19163) (18239) (17315)
1949 (17308) (16673) (16038)
1950 (13187) (12701) (12215)
1951 (10706) (10035) (9363)
1952 (3800) (3921) (4042)
1953 (2834) (2881) (2927)
1954 (5044) (4832) (4620)
1955 (290) (400) (510)
1956 484 515 547
1957 359 562 765
1958 (1357) (991) (625)
1959 538 744 0
1960 428 931 0
1961 738 984 0
1962 1093 1445 0
1963 84 796 0
1964 794 1329 0
1965 1175 1398 0
1966 1009 0 0
1967 (934) 936 0
1968 (1079) 1417 0
1969 (2073) 1485 0
1970 (8510) (2082) 0
1971 (6465) (1831) 0
1972 (2929) (317) 0
1973 (251) 592 0
1974 (2148) (1268) (388)
1975 (11406) (10180) (8953)
1976 (3222) (3161) (3100)
1977 (286) (736) (1187)
1978 (322) (914) (1505)
1979 721 30 (661)
1980 1669 956 242
Have fun.
John R.
Failed: Without Rebalancing
Year, Failures (negative balances) at year 30 for withdrawal rates of 3%, 4% and 5%
Have fun.
John R.
Year, Failures (negative balances) at year 30 for withdrawal rates of 3%, 4% and 5%
Code: Select all
1921 0 0 0
1922 0 0 0
1923 0 0 0
1924 0 0 0
1925 0 0 0
1926 0 0 0
1927 0 0 0
1928 0 0 0
1929 0 0 1
1930 0 0 1
1931 0 0 1
1932 0 0 0
1933 0 0 0
1934 0 0 0
1935 0 0 0
1936 0 0 1
1937 0 0 1
1938 0 0 0
1939 0 0 1
1940 0 0 1
1941 0 0 0
1942 0 0 0
1943 0 0 0
1944 0 0 0
1945 0 0 0
1946 0 0 0
1947 0 0 0
1948 0 0 0
1949 0 0 0
1950 0 0 0
1951 0 0 0
1952 0 0 0
1953 0 0 0
1954 0 0 0
1955 0 0 0
1956 0 0 0
1957 0 0 0
1958 0 0 0
1959 0 0 1
1960 0 0 1
1961 0 0 1
1962 0 0 1
1963 0 0 1
1964 0 0 1
1965 0 0 1
1966 0 1 1
1967 0 0 1
1968 0 0 1
1969 0 0 1
1970 0 0 1
1971 0 0 1
1972 0 0 1
1973 0 0 1
1974 0 0 0
1975 0 0 0
1976 0 0 0
1977 0 0 0
1978 0 0 0
1979 0 0 0
1980 0 0 0
John R.
Failed: With Rebalancing
Year, Failures (negative balances) at year 30 for withdrawal rates of 3%, 4% and 5%
Have fun.
John R.
Year, Failures (negative balances) at year 30 for withdrawal rates of 3%, 4% and 5%
Code: Select all
1921 0 0 0
1922 0 0 0
1923 0 0 0
1924 0 0 0
1925 0 0 0
1926 0 0 0
1927 0 0 0
1928 0 0 0
1929 0 0 1
1930 0 0 1
1931 0 0 1
1932 0 0 0
1933 0 0 0
1934 0 0 0
1935 0 0 0
1936 0 0 1
1937 0 0 1
1938 0 0 0
1939 0 0 1
1940 0 0 0
1941 0 0 0
1942 0 0 0
1943 0 0 0
1944 0 0 0
1945 0 0 0
1946 0 0 0
1947 0 0 0
1948 0 0 0
1949 0 0 0
1950 0 0 0
1951 0 0 0
1952 0 0 0
1953 0 0 0
1954 0 0 0
1955 0 0 0
1956 0 0 0
1957 0 0 0
1958 0 0 0
1959 0 0 1
1960 0 0 1
1961 0 0 1
1962 0 0 1
1963 0 0 1
1964 0 0 1
1965 0 0 1
1966 0 1 1
1967 0 0 1
1968 0 0 1
1969 0 0 1
1970 0 0 1
1971 0 0 1
1972 0 0 1
1973 0 0 1
1974 0 0 0
1975 0 0 0
1976 0 0 0
1977 0 0 0
1978 0 0 0
1979 0 0 0
1980 0 0 0
John R.
Typically, there was a penalty for rebalancing.
I haven't devoted much thought to the rebalancing question. All of the thoughts set forth below are tenative ones. I really am just thinking aloud in the writing of this post.
My initial reaction is that the rebalancing concept in in direct contradiction to the buy-and-hold concept. To the extent that buy-and-hold is a good idea, rebalancing is a bad idea. And to the extent that rebalancing is a good idea, buy-and-hold (at least the currently prevailing understanding of what it requires) is a bad idea.
What does it mean to "buy-and-hold?" It means to stick with a strategy long enough for it to pay off, to not permit changes in the moods of Mr. Market to dictate your investment decisions. In most circumstances, that makes a lot of sense. You generally are going to come to better decisions when you are thinking things through carefully before the battle begins rather than in the heat of battle when your emotions are likely to sway you in the wrong direction. So buy-and-hold generally pays off.
To say that you are going to rebalance is to say that you possess less than complete confidence in your buy-and-hold strategy. Say that your strategy is to go with 60 percent stocks and 40 percent bonds. You decide on that allocation because your analysis shows that it has the best chance of prevailing in the long term. Stocks go up dramatically, causing the stock portion of your portfolio to grow to more than 60 percent. You sell stocks to get back to a 60 percent allocation. You are NOT sticking with the original allocation, you are NOT sticking with the original strategy. You are sticking with the original percentage, which requires the sellling of stocks. It is Mr. Market that is causing you to make this change. You are permitting Mr. Market to dictate your investment choices.
What makes rebalancing appealing is that, when you sell stocks after a price run-up, you do not appear to be responding emotionally. The emotional choice would be to buy more stocks in a price run-up, and you are instead selling. You are selling high, and that is what the "buy low, sell high" maxim says you should do. So you are going against your emotional pull and doing just the right thing.
It is true that rebalancing causes you to move in a direction counter to the direction in which your emotions would pull you. In that sense, rebalancing is good. The fact remains, however, that rebalancing also runs counter to the buy-and-hold philosophy. You are NOT sticking with your original strategy when you rebalance. You are not giving it time to pay off. You are modifying your original strategy in response to the actions of Mr. Market.
The root problem is not with the rebalancing concept per se. The root problem is with the idea that an investor should have the same allocation to stocks at all times. That idea is just flat-out wrong. The data does not support that idea. Rebalancing is just a tactic that has been developed to get the investor back to the starting-point allocation percentage, which has been presumed to possess magical powers. There is no one allocation percentage that is optimal at all times for all investors. The search for one "optimal" allocation is a search for water that is dry or for darkness that helps one see better. We will never determine the one "optimal" allocation because the optimal allocation varies over time. What is "optimal" always depends on what prices apply to stocks at a given moment.
Rebalancing counters buy-and-hold. I like "buy-and-hold," so I don't see that as being such a good thing. But it is being employed by investors who are employing a version of buy-and-hold that does not make much sense, a version in which you buy-and-hold the same percentage of stocks regardless of the valuation levels that apply. In these circumstances, rebalancing can serve a good purpose when it causes those with excessively high stock allocations to lower their stock allocations a bit.
My view is that we need a new understanding of what is entailed by the phrase "buy-and-hold." I think that the idea has great power--You need to stick with a strategy long enough for it to pay off. The flaw in the currently prevailing view of buy-and-hold is the idea that one should decide how much in the way of stocks one should buy-and-hold without taking valuation levels into account. If you took valuation levels into account when you decided on what percentage of stocks to hold, it would seem to me that you would not need to worry about rebalancing. You would just change your stock allocations through the working of your original strategy as events played out over time.
Someone who followed a long-term timing strategy would be (in some circumstances, but by no means in all circumstances) selling stocks after price run-ups and buying them after price drops, just as would those who rebalance. But he would be doing so in a way that was consistent with his starting point strategy rather than in contradiction to it. The starting-point strategy and the implementation strategy would be integrated.
I think that the appeal of rebalancing is due to the fact that investors sense that ignoring valuations does not really make sense. Rebalancing is really a form of timing. It is changing allocations in response to changes in prices. Its flaw is that it is an arbitrary use of a timing tactic within an overall overall strategy that rejects the use of timing. The right way to tap into the benefits of timing is at the time when the portfolio is being constructed. Changes made during the implementation of the plan should be consistent with the starting-point strategy rather than in conflict with it.
I haven't devoted much thought to the rebalancing question. All of the thoughts set forth below are tenative ones. I really am just thinking aloud in the writing of this post.
My initial reaction is that the rebalancing concept in in direct contradiction to the buy-and-hold concept. To the extent that buy-and-hold is a good idea, rebalancing is a bad idea. And to the extent that rebalancing is a good idea, buy-and-hold (at least the currently prevailing understanding of what it requires) is a bad idea.
What does it mean to "buy-and-hold?" It means to stick with a strategy long enough for it to pay off, to not permit changes in the moods of Mr. Market to dictate your investment decisions. In most circumstances, that makes a lot of sense. You generally are going to come to better decisions when you are thinking things through carefully before the battle begins rather than in the heat of battle when your emotions are likely to sway you in the wrong direction. So buy-and-hold generally pays off.
To say that you are going to rebalance is to say that you possess less than complete confidence in your buy-and-hold strategy. Say that your strategy is to go with 60 percent stocks and 40 percent bonds. You decide on that allocation because your analysis shows that it has the best chance of prevailing in the long term. Stocks go up dramatically, causing the stock portion of your portfolio to grow to more than 60 percent. You sell stocks to get back to a 60 percent allocation. You are NOT sticking with the original allocation, you are NOT sticking with the original strategy. You are sticking with the original percentage, which requires the sellling of stocks. It is Mr. Market that is causing you to make this change. You are permitting Mr. Market to dictate your investment choices.
What makes rebalancing appealing is that, when you sell stocks after a price run-up, you do not appear to be responding emotionally. The emotional choice would be to buy more stocks in a price run-up, and you are instead selling. You are selling high, and that is what the "buy low, sell high" maxim says you should do. So you are going against your emotional pull and doing just the right thing.
It is true that rebalancing causes you to move in a direction counter to the direction in which your emotions would pull you. In that sense, rebalancing is good. The fact remains, however, that rebalancing also runs counter to the buy-and-hold philosophy. You are NOT sticking with your original strategy when you rebalance. You are not giving it time to pay off. You are modifying your original strategy in response to the actions of Mr. Market.
The root problem is not with the rebalancing concept per se. The root problem is with the idea that an investor should have the same allocation to stocks at all times. That idea is just flat-out wrong. The data does not support that idea. Rebalancing is just a tactic that has been developed to get the investor back to the starting-point allocation percentage, which has been presumed to possess magical powers. There is no one allocation percentage that is optimal at all times for all investors. The search for one "optimal" allocation is a search for water that is dry or for darkness that helps one see better. We will never determine the one "optimal" allocation because the optimal allocation varies over time. What is "optimal" always depends on what prices apply to stocks at a given moment.
Rebalancing counters buy-and-hold. I like "buy-and-hold," so I don't see that as being such a good thing. But it is being employed by investors who are employing a version of buy-and-hold that does not make much sense, a version in which you buy-and-hold the same percentage of stocks regardless of the valuation levels that apply. In these circumstances, rebalancing can serve a good purpose when it causes those with excessively high stock allocations to lower their stock allocations a bit.
My view is that we need a new understanding of what is entailed by the phrase "buy-and-hold." I think that the idea has great power--You need to stick with a strategy long enough for it to pay off. The flaw in the currently prevailing view of buy-and-hold is the idea that one should decide how much in the way of stocks one should buy-and-hold without taking valuation levels into account. If you took valuation levels into account when you decided on what percentage of stocks to hold, it would seem to me that you would not need to worry about rebalancing. You would just change your stock allocations through the working of your original strategy as events played out over time.
Someone who followed a long-term timing strategy would be (in some circumstances, but by no means in all circumstances) selling stocks after price run-ups and buying them after price drops, just as would those who rebalance. But he would be doing so in a way that was consistent with his starting point strategy rather than in contradiction to it. The starting-point strategy and the implementation strategy would be integrated.
I think that the appeal of rebalancing is due to the fact that investors sense that ignoring valuations does not really make sense. Rebalancing is really a form of timing. It is changing allocations in response to changes in prices. Its flaw is that it is an arbitrary use of a timing tactic within an overall overall strategy that rejects the use of timing. The right way to tap into the benefits of timing is at the time when the portfolio is being constructed. Changes made during the implementation of the plan should be consistent with the starting-point strategy rather than in conflict with it.
Rebalancing is a limited form of switching/market timing. It is not surprising that it works best at higher valuations, since that is when switching away from stocks statistically adds value. (Stocks go up most of the time, so rebalancing will mostly move people out of equities.)Right now, today, rebalancing is a good idea. These are stressful times.
hocus2004 and Mike are right about valuations and timing.
They form the core issue.
Many, if not all, mechanical strategies are built around the assumption that you can do little or nothing meaningful in the way of measuring and exploiting value.
Value strategies are built on the assumption that you can measure valuation in a meaningful way. Even though you do not know exactly when a company's true (or intrinsic) value will be recognized, you can be confident that it will be recognized within a broadly defined time period. Some would say within a decade. Others would say longer.
Two groups send out the wrong message.
Many people get in trouble because they think that they can measure intrinsic value much more accurately than they can and because they are unwilling to wait for the market to recognize value.
Academic researchers tend to cloud the issue because of the difficulty in modeling value strategies correctly. Typically, they examine investment strategies that are force-fit to match their models, requiring too much trading for too little reward.
Have fun.
John R.
They form the core issue.
Many, if not all, mechanical strategies are built around the assumption that you can do little or nothing meaningful in the way of measuring and exploiting value.
Value strategies are built on the assumption that you can measure valuation in a meaningful way. Even though you do not know exactly when a company's true (or intrinsic) value will be recognized, you can be confident that it will be recognized within a broadly defined time period. Some would say within a decade. Others would say longer.
Two groups send out the wrong message.
Many people get in trouble because they think that they can measure intrinsic value much more accurately than they can and because they are unwilling to wait for the market to recognize value.
Academic researchers tend to cloud the issue because of the difficulty in modeling value strategies correctly. Typically, they examine investment strategies that are force-fit to match their models, requiring too much trading for too little reward.
Have fun.
John R.
Let me add a few comments along these lines.Mike wrote:Rebalancing is a limited form of switching/market timing. It is not surprising that it works best at higher valuations, since that is when switching away from stocks statistically adds value. (Stocks go up most of the time, so rebalancing will mostly move people out of equities.)Right now, today, rebalancing is a good idea. These are stressful times.
The hobby stock portfolio of 100% stocks is usually superior to the core portfolio, which is split equally between stocks and Treasury Bills.
If the two portfolios were equally attractive, results would favor rebalancing most of the time. For both portfolios to be equally attractive, they would have to have the same rate of return on average. Having Treasury Bills in the core portfolio causes it to be inferior under typical circumstances. Rebalancing is inferior most of the time because the rebalancing bonus is not sufficient to overcome the performance drag caused by holding Treasury Bills.
We can easily recognize when rebalancing is a better choice. It is when holding stocks is dangerous. Holding stocks is dangerous when valuations are high.
Have fun.
John R.
Since asset classes such as commodities, and SCV have rates of return equal to or better than the S&P, rebalancing with them would seem to have a better chance of adding value.Rebalancing is inferior most of the time because the rebalancing bonus is not sufficient to overcome the performance drag caused by holding Treasury Bills.
I was unaware of this in terms of commodities. I thought that commodities themselves have delivered inferior performance except during times of high inflation.Mike wrote:Since asset classes such as commodities, and SCV have rates of return equal to or better than the S&P, rebalancing with them would seem to have a better chance of adding value.Rebalancing is inferior most of the time because the rebalancing bonus is not sufficient to overcome the performance drag caused by holding Treasury Bills.
It may be that investments related to commodities (such as share of commodity producers) provide good returns.
Have fun.
John R.
Continuing the grand tradition: "If the ducks are quacking, feed them." - Wall Street has rolled out some commodity mutual fund type products.
Pimco seems the most interesting. Radr's forum/website has done some interesting work in this area. I'm a Boglehead more than a 'slice and dicer' - but I continue to monitor their work with more than casual interest.
Getting back to the home front:
Nephew 2: age 25, single, military 'lifer' - Continue to DCA via TSP into Vanguard TSM - revisit in thirty years(from start date).
Nephew 1: age 31, married, first child due in April, also career military, - leave first, age 21-31, ten years of DCA TSM alone - take care of near term - house down payment, etc, etc with shorter term investments. Come back to the original when you are 'old' and ready to retire to see what 'time in the market and compounding has done'.
Us'in's: age 61/62, eleven years into ER, two early SS streams this year plus two small pensions:
Dump REITs, Lifestrategy, - go Vanguard Target Retirement Series blended to get 30 - 40% stocks and start taking out the portfolio yield.
Excess above the budget goes into dividend stocks. Screw conventional calculators - I'm thinking ORP which tells me to spend taxable first, then IRA when RMD at 70 1/2 kicks in. If 'future expected returns' are much lower due to high valuations, then the power of compounding tax deferred is lessened.
Still cogitating running some calculators(ORP and FireCalc) on this one. But my old school brain thinks in income streams:
1. Pensions - basically non - cola
2. SS his and hers - inflation adjusted
3. Dividend stocks - some inflation combating capibility over time
4. Target Retirement set close to Vanguard's age related recommendation and take out the yield(div/interest). Latitude to shift up in stocks if valuations get better in the next 25 years.
I like the four legged table of income streams: even if all the legs are not exactly equal - fits my way of thinking.
Pimco seems the most interesting. Radr's forum/website has done some interesting work in this area. I'm a Boglehead more than a 'slice and dicer' - but I continue to monitor their work with more than casual interest.
Getting back to the home front:
Nephew 2: age 25, single, military 'lifer' - Continue to DCA via TSP into Vanguard TSM - revisit in thirty years(from start date).
Nephew 1: age 31, married, first child due in April, also career military, - leave first, age 21-31, ten years of DCA TSM alone - take care of near term - house down payment, etc, etc with shorter term investments. Come back to the original when you are 'old' and ready to retire to see what 'time in the market and compounding has done'.
Us'in's: age 61/62, eleven years into ER, two early SS streams this year plus two small pensions:
Dump REITs, Lifestrategy, - go Vanguard Target Retirement Series blended to get 30 - 40% stocks and start taking out the portfolio yield.
Excess above the budget goes into dividend stocks. Screw conventional calculators - I'm thinking ORP which tells me to spend taxable first, then IRA when RMD at 70 1/2 kicks in. If 'future expected returns' are much lower due to high valuations, then the power of compounding tax deferred is lessened.
Still cogitating running some calculators(ORP and FireCalc) on this one. But my old school brain thinks in income streams:
1. Pensions - basically non - cola
2. SS his and hers - inflation adjusted
3. Dividend stocks - some inflation combating capibility over time
4. Target Retirement set close to Vanguard's age related recommendation and take out the yield(div/interest). Latitude to shift up in stocks if valuations get better in the next 25 years.
I like the four legged table of income streams: even if all the legs are not exactly equal - fits my way of thinking.
You are talking about commodity futures, not commodities themselves.
It is one thing to own a farm. It is another thing to own the rights to this year's crop.
Commodity futures have a bad reputation.
1) In a Barron's commentary, Alex Abelson mentioned that there are no long-term success stories among commodity traders. A little earlier, there had be a single, fabulously successful success story. The commentary was written after this sole exception had gone bankrupt.
2) Commodity futures are noted for high rates of return and high volatility. But that is before commissions. Less well known is that commissions are high as well. They wipe out most of the upside.
Interestingly, commodities futures follow the insurance company pattern that Benoit Mandelbrot mentioned specifically in his book, The (Mis)behavior of Markets. The futures market in cotton should have been immensely profitable. And it is, most of the time. But every now and then, a series of unlikely disasters happen, all in a row, one right after another. That is when traders (and farmers) go belly up.
Commodity futures are exceedingly hazardous.
I dare not go down that path.
Have fun.
John R.
It is one thing to own a farm. It is another thing to own the rights to this year's crop.
Commodity futures have a bad reputation.
1) In a Barron's commentary, Alex Abelson mentioned that there are no long-term success stories among commodity traders. A little earlier, there had be a single, fabulously successful success story. The commentary was written after this sole exception had gone bankrupt.
2) Commodity futures are noted for high rates of return and high volatility. But that is before commissions. Less well known is that commissions are high as well. They wipe out most of the upside.
Interestingly, commodities futures follow the insurance company pattern that Benoit Mandelbrot mentioned specifically in his book, The (Mis)behavior of Markets. The futures market in cotton should have been immensely profitable. And it is, most of the time. But every now and then, a series of unlikely disasters happen, all in a row, one right after another. That is when traders (and farmers) go belly up.
Commodity futures are exceedingly hazardous.
I dare not go down that path.
Have fun.
John R.