(PUB) Investing 2016

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the shortest period between trades was just three months, and the longest was more than eight years. Consider that following the 10% strategy would have dictated trad- ing into stocks at the end of October 2008, after the market fell 24.2% in September and October. Could you have done that? Would you have done that? How about in February 2009, when the portfolio you rebalanced in October once again was more than 10% out of whack? Would you have had to nerve to buy stocks at what, in retro- spect, was the absolute bottom of the financial crisis bear market? As I said, it’s easy to talk about rebalancing—it’s a lot harder to do it, particularly in peri- ods when it provides the most benefit. Okay, maybe 10% is too much. How about 5%? Well, those 46 trades, which average out to about one trade every seven months, or less than two per year, didn’t occur with lots of regularity either. In fact, during 2008 and 2009 alone, you’d have executed nine trades. And that meant selling bonds to buy stocks into the teeth of the credit crisis in 2008 and early 2009, only to turn around and sell stocks to buy bonds as markets rebounded in late 2009. Easier said than done. As I mentioned at the outset, therein lies the main issue with rebalancing strat- egies of all stripes: The investor can at times be his own worst enemy. I’ll return to this point after looking at Vanguard’s latest rebalancing recommendation. Combine theTwo? As I mentioned, Vanguard’s latest advice combines both a periodic review with the threshold strategy. Specifically, Vanguard concludes that “for most broadly diversified stock and bond fund portfolios… annual or semiannual monitoring, with rebalancing at 5% thresholds , is likely to produce a rea-

sonable balance between risk control and cost minimization for most inves- tors. Annual rebalancing is likely to be preferred when taxes or substantial time/ costs are involved.” Vanguard’s whitepaper has some numbers in it, but of course Dan and I wanted to take our own look. We put our 50/50 portfolio through Vanguard’s recommended strategies: First, rebal- ancing annually in January if the dif- ference between stock and bond alloca- tions was 5% or greater at the end of the year. Then running the same exer- cise, but looking to rebalance in both January and July if the portfolio was past the 5% skew. As you can see, the top left chart on the next page doesn’t look all that different from either the periodic or threshold-only charts. Following the annual review with rebalancing at a 5% threshold would have seen you trade the portfolio in 18 out of the 29 years, or 62% of the time. And reviewing the portfolio semiannu- ally would’ve resulted in 23 trades. So combining the periodic and threshold approaches does reduce the number of times you trade, versus either strategy individually, but at the end of the day, you are winding up in the same place. Trading Has Its Costs The strongest argument against becoming a rebalancing fanatic is cost— something which I don’t believe gets enough analysis in all the blather over rebalancing. So far when conducting this analysis, I assumed that all distributions were reinvested along the way, and did not factor in transaction fees or taxes on

buying and holding. The first required a reset to 50/50 whenever the difference between stock and bond allocations was 5% or greater. The second trigger for an adjustment was a 10% allocation differ- ential. Not surprisingly, you can see the static portfolio’s outperformance surging in the late 1990s and its minor underper- formance from the depths of the recent bear market in the chart below to the right, which looks a lot like the chart on page 13 of the calendar-based rebalanc- ing strategies. The numbers in the table below con- firm that periodic and threshold rebal- ancing get you to the same place with similar risks. As I said before, rebalanc- ing is about risk control, not improv- ing returns—and no single rebalancing strategy trumps another. The threshold strategy is popular in the press and academia, but consider the kind of trading this strategy gener- ates. As I go through the numbers, ask yourself whether you could or would follow such a strategy on your own. Obviously, if you don’t rebalance, there are no trades required. But if you decided to trade your 50/50 portfo- lio whenever the allocations between stocks and bonds broadened out by 10% or more, you’d have made 16 trades over the past three decades or so. That sounds pretty reasonable, right? Heck, even a strategy that rebalanced on 5% spreads would have generated just 46 trades, or fewer than two per year. That sounds doable, right? The trouble is that rebalancing on percentage thresholds can mean going years without a trade, and then making a flurry of changes. And it can mean making trades at times when those trades are the hardest to execute. Take a look at the table below. As mentioned, while the 10% strategy only necessi- tated 16 trades in nearly three decades,

Lots of Work, Little Payoff

$1,200

No Rebalancing 10% Rebalancing 5% Rebalancing

$1,000

$800

Easy on Paper, Not So Easy To Do

$600

Avg. Mos. Btwn. Trades

Fewest Mos. Btwn. Trades

Most Mos. Btwn. Trades

Terminal Value of $100

Basis Pt Diff.

$400

Annualized Return

Trades

MCL

$200

No rebalancing

0 — — — $1,067

8.50% -34.5% 8.33% (17) -28.4% 8.42% (8) -26.9%

$0

Rebalancing on a 10% spread 16 22

3 1

99 $1,020 50 $1,045

Rebalancing on a 5% spread

46

7

12/87

12/91

12/95

12/99

12/03

12/07

12/11

12/15

Note: Table shows results for a portfolio allocated 50/50 to 500 Index and Total Bond Market from Dec. 1986 through Dec. 2015.

Note: Threshold-based rebalancing strategies.

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