(PUB) Investing 2016

the differences were tiny. For instance, the annual rebalancing strategy gener- ated a total return over the entire period that was just 5 basis points, or 0.05%, per annum off the pace of the no- rebalancing strategy. On a $100 initial investment that translates into a differ- ence of $14 at the end of the 29-year period—$1,067 vs $1,054. A non-trivial piece missing from my calculation is the impact of taxes from rebalancing’s trading activity. Assume even a small amount of taxes, and the rebalancing strategies fall further behind the no-rebalancing strategy in terms of total performance. So, from a volatility and drawdown standpoint, rebalancing does have a risk-reducing effect on a portfolio if you happen to go through a big enough bear market—you won’t hit the same interim heights, but neither will you experience the same interim losses. HittingYourThreshold Okay, that’s the periodic rebalanc- ing strategy. What about the one that says you should rebalance when your allocations are 5%, or even 10%, out of whack? This is a popular recommen- dation, but the results really aren’t all that different from the calendar-based approaches. Again, I took a 50/50 portfolio and set up two scenarios beyond simply >

because over long periods of time you tend to sell assets with greater return potential (stocks) to buy something that will likely return less (bonds). To say that there are myriad rebalanc- ing strategies foisted upon the investing public would be a vast understatement. The two most common rebalancing schemes focus on either the calendar (instructing investors to rebalance every month, six months, year, or three years) or on how far your portfolio allocation skews beyond a percentage threshold you’ve established, say 5% or 10%. Vanguard published a whitepa- per, Best Practices for Portfolio Rebalancing , which examined various rebalancing strategies. In the end, the authors recommend combining the two standard approaches: Review your port- folio on a periodic basis, and if the portfolio allocation has skewed 5% at that time, then rebalance. Here’s the issue: While these sugges- tions sound great on paper, in the real world their efficacy is suspect. Let’s take each recommendation in turn. Time-Dependent Rebalancing Let’s start with the impact of time- dependent rebalancing on the same 50/50 stock/bond fund portfolio I described above. I have set up a few rebalancing sce- narios. In the first, I rebalanced the port- folio every six months—once in January, and again in July. In the second test, I rebalanced once a year in January, and in the third I took the long view and rebal- anced every third January. Naturally, I also compared the results of these strate- gies with the “never rebalanced” portfo- lio. (Also, you may be wondering why I picked January for rebalancing. I figured that if it’s a mechanical system, it’s best to make your trades after December dis- tributions have been paid out and the tax year has turned.) What you can see in the chart above is that after nearly 30 years through the end of 2015, the differences between several regular rebalancing strategies and the no-rebalancing strategy are pretty minor. And, other than at market extremes, like the late-1990s period before the bursting of the tech bubble

Rebalancing Is About Risk

$1,200

Semiannual Annual Every 3 Years Never

$1,000

$800

$600

$400

$200

$0

12/87

12/91

12/95

12/99

12/03

12/07

12/11

12/15

Note: Calendar-based rebalancing strategies.

and the decline from the top of the market in October 2007, it’s pretty hard to distinguish one line in the chart from another. The data in the table below confirms it. Whether you are comparing the total returns, the rolling one-, three- and five-year returns or the maximum cumulative losses (MCL) between the rebalancing strategies over the entire period, you can’t definitively say that one rebalancing method trumps anoth- er. And, as I said at the outset, rebalanc- ing is all about controlling risk. Each rebalancing strategy yielded a mean- ingfully smaller maximum cumulative loss (MCL) than the 34.5% decline suffered by the no-rebalancing strategy. However, all slightly underperformed the no-rebalancing portfolio, though

Rebalancing’s Benefits Are Minimal Semiannual rebalancing 1-month 1-year 3-year 5-year

Basis Pt. Diff.

———— ROLLING RETURNS ———— Terminal Value of $100

Annualized Return

MCL

Best

7.3% 30.2% 20.6% 17.9% 0.7% 8.7% 8.6% 8.4%

Average

Worst

-9.7% -22.2% -4.8% -1.0% $1,031

8.37% (13)

-26.1%

Annual rebalancing Best

7.3% 30.9% 20.8% 18.1% 0.7% 8.8% 8.7% 8.5%

Average

Worst

-11.3% -21.3% -4.5% -0.8% $1,054

8.45% (5)

-25.2%

Rebalancing every 3 years Best

7.3% 32.0% 21.6% 18.7% 0.7% 8.7% 8.6% 8.4%

Average

Worst

-11.3% -19.4% -3.8% -0.3% $1,024

8.35% (16)

-23.6%

Never rebalancing Best

7.7% 36.6% 24.0% 21.3% 0.7% 9.1% 8.8% 8.4%

Average

Worst

-11.8% -28.5% -9.0% -2.6% $1,067

8.50% — -34.5%

Note: Multiyear returns are annualized.

The Independent Adviser for Vanguard Investors • February 2016 • 13

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