(PUB) Investing 2016

REBALANCING To Re or Not to Re, That Is the Question

of cherry-picking that goes along with these studies). The question of when, why and how you should rebalance your portfolio also garners plenty of media attention on a cyclical basis, and yet, despite all of the column inches devoted to the subject and nudges from fund companies, the conclusions are often the same: Sell your winners and buy your losers. Beyond that, there is absolutely no cut-and-dried strategy that wins the rebalancing wars, although there are plenty who’ll tell you they’ve got the magic formula. And by the way, that formula keeps changing. In managing its ETF strate- gic portfolios (yes, Vanguard has ETF- only portfolios) Vanguard switched from semiannual to quarterly to monthly rebal- ancing over time. You’ll find other rebal- ancing approaches employed and pro- moted within the firm. Even Vanguard doesn’t have a single preferred strategy. But let’s ask the basic question: Is rebalancing really a panacea? And if so, what kind of rebalancing is best? Dan and I spent some time digging into the numbers you’ll see below, but we’ve come to the conclusion that long- term investors never need to rebalance. (Well, almost never, and I’ll get to that in a minute.) As Vanguard founder Jack Bogle has said, “Formulaic rebalancing with precision is not necessary.” Managing Risk Proponents of rebalancing often say that is a disciplined way to sell high (selling what has done well) and buy low (buying what has lagged). And buying low and selling high has always been the formula for boosting returns. As you’ll see, rebalancing is really all about risk control—by sticking to a targeted allocation between stocks and bonds, the argument follows, you can effectively manage the overall risk or volatility of your portfolio through continuing market cycles. In the end, however, you don’t end up improving returns through systematic rebalancing,

IT MAY BE one of the most common questions investors ask every year as December turns to January. Should I rebalance or not? The dramatic start to 2016, with 500 Index dropping 5.0% and Total Bond Market Index gaining 1.4%, is an awfully good time to address this ques- tion. If, at the start of the year, your port- folio was evenly divided between these two funds, some rebalancing strategies would have dictated that you sell some of your bonds to buy more stocks at the end of January. Could you have done that, and would you have done that? You just put half your money to work in stocks, only to see it fall 5.0%, and now are supposed to buy more. Easier said than done. And that’s one of the three lessons I hope you’ll take away from this discussion of rebalancing: It’s easy to dictate rules for investing in backtests, but much more difficult to execute them in real life. The other two takeaways? First, rebalancing is all about managing risk, not improving returns—in fact, after costs and taxes, rebalancing almost cer- tainly reduces your returns over time. Second, you may not need or want to rebalance like clockwork in the first place, but if you do, follow your strat- egy to the letter. I’ll come back to each of those points throughout this article, but let’s start at the beginning. Rebalancing is a strategy where you determine an initial, desired allocation for your portfolio—say 50% stocks and 50% bonds—and then, over time, trade your portfolio back to that starting mix. To use the standard exam- ple, I looked at a 50/50 mix of stock and bond funds in a portfolio, using 500 Index and Total Bond Market Index as my proxies going all the way back to Total Bond Market Index’s inception in December 1986. ( Total Stock Market didn’t see the light of day until April 1992, hence my use of 500 Index.) The chart above shows how that portfolio’s allocations would have changed over

Never Rebalancing Leads to Stocks “Taking Over”

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Total Bond Market 500 Index

12/87

12/91

12/95

12/99

12/03

12/07

12/11

12/15

time if you never rebalanced. Stocks tend to outperform bonds, and hence 500 Index came to represent a larger and larger piece of the portfolio over time. For instance, at the end of 2015, that original 50/50 portfolio would have morphed into one with 73% of its assets in stocks. Some investors, having seen the stock market outperform the bond mar- ket between 1986 and 2015 might say, “Well, I’m glad I have more money in stocks today.” But that defeats the purpose of rebalancing, which is meant to support the original decision to have one’s allocation be (in this case) a 50/50 mix, not a 73/27 mix. The Vanguard Way Vanguard loves rebalancing. It is one of the “disciplined investment princi- ples” that its Personal Advisor Service follows in managing client portfolios. Vanguard’s website regularly features articles and suggestions about the ben- efits that rebalancing provides (such as the moves you can make for yourself, or the regular rebalancing that occurs within its funds-of-funds as cash flows in and out). Vanguard, of course, is not the only voice on rebalancing. The other robo- advisers, Betterment and Wealthfront, claim that, for instance, rebalancing can add 0.4% to your performance per year (though I think there’s a lot

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