What’s the right way to rebalance a portfolio is a question often asked and about as simple to answer as what’s the right way to end a relationship – the results vary according to circumstance and personal style.
A number of different portfolio rebalancing methods exist, but there’s no clear-cut evidence that there is one system to rule them all.
Research by the respected fund shop Dimensional Fund Advisors concludes:
There is no easy one-size-fits-all rebalancing solution. Rebalancing decisions should be driven by the need to maintain an allocation with a risk and return profile appropriate for each investor.
The optimal rebalancing strategy will differ for each investor, depending on their unique sensitivities to deviations from the target allocation, transaction frequency, and tax costs.
When it comes to rebalancing, like so many things in life, it’s doing it that counts, not exactly how you do it.
Calendar rebalancing
So, as passive investors like to keep things simple, you can go easy on yourself and plump for the most straightforward option: Calendar rebalancing.
Just pick a date and your rebalancing frequency:
Quarterly
Semi-annually
Annually
Every 2-3 years
When the clock strikes, you review how far your current asset allocations have drifted from your target weightings. And then you take action:
Sell the out-performers
Buy the under-performers
Do so in proportions that return your portfolio to its target allocations
This apparent act of madness is banking on mean-reversion; you aim to cash in on the shooting stars before they fall back to Earth, while potentially turning today’s dogs into tomorrow’s winners.
Beware! The more often you rebalance, the more likely you are to curtail the superior returns of the winners before they turn into losers – essentially because you cut the winning run short.
The advantage of frequent rebalancing is that you’re less likely to be over-exposed to an asset on the rampage, and so avoid excess pain when the sell-off begins.
Many finance professionals urge frequent rebalancing as a way of enhancing returns. But reliable evidence for this is scant, as it really depends on how you cut the stats to suit your argument.
The known cost of rebalancing
What is certain is that frequent rebalancing increases trading costs and potentially your tax liabilities. That can be more than enough to wipe out any chance of a rebalancing bonus.
I prefer to rebalance no more than once a year. That gives winning assets a reasonable time to go on a run, but also means I check in often enough to correct any major deviations caused by frothy markets.
“Rebalance your portfolio approximately once every few years; more than once per year is probably too often. In taxable portfolios, do so even less frequently.”
The weakness of infrequent calendar rebalancing is that it can leave you exposed to big changes in your portfolio – occurring over short periods of time – when markets are volatile. The answer to that is threshold rebalancing.
I think we’re nearly all agreed now that UK property prices are too high, and in the South East at historically stretched levels compared to rents or incomes.
(Okay, so my mum is a holdout. She rightly views my housing sob story as leavened by a substantial dollop of my own personal failings… I think she also wants to see a granny annex in her future!)
You do still hear from the odd Barry Blimp who says that it was just as difficult to buy in his day, when he bought a three-bedroom house in Zone 2 in London aged 25-years old on his graduate salary – and that he managed it because he didn’t own an iPhone.
But even most naysayers have shifted to tell you that fine, yes, house prices are absurd, but what’s so bad about renting anyway?
This view is invariably advanced by people who haven’t rented for decades, and often as not who’s only recent contact with a tenancy contract is the one they just got signed for their latest buy-to-let.
Down and out in London and Bristol and Oxford and…
Meanwhile people who feel locked out of the property market know that it’s not just a matter of being allowed to bang nails into the walls to put up their own IKEA pics.
They can see how not owning housing – geared up via a mortgage to lottery-level winnings for older generations – has left them floundering in the wake.
I see this illustrated all the time with my 40-something London friends.
The majority who bought in their 20s never stop taking holidays, eating out, and buying fancy bits and bobs.
The few who didn’t even avoid having too many Sunday lunches in the local gastropub – or go the other way, throw in the towel, and spend their large yet useless deposits on year-long hedonistic benders. (i.e. A bit of travel).
As for my 20-something friends, they live from paycheck to paycheck and imagine owning a one-bed flat with the same sense of wonder with which the Baby Boomers viewed the moon landings.
Before anyone gets out their tiny violins, I’m not talking about me. My lifetime savings rate has been very high, and my investment returns above average. As a result I’ve amassed a chunky warchest. I could buy, but I don’t.
However I don’t think it’s reasonable to expect an entire generation of bright young people to turn themselves into a Scroogier version of Warren Buffet just to do what their parents did as a matter of course.
Fine, perhaps this is the way the market will be for the foreseeable future. But if we’re being pragmatic then we should at least acknowledge the strain it is putting on social norms.
The return of feudalism
In particular young people – who also face student debts, high rents, low wages, unfunded pensions, and no chance of a BTL windfall – will get relatively poorer even if they do the right thing, unless some sort of action is taken.
Business Insider recapped a Resolution Foundation paper this week that shows how property ownership in the UK is driving inequality.
It notes that:
Britain has changed since 1998.
Back then, it only took workers about three years to save enough money for a down-payment on a house.
Now it takes 20 years, on average.
(Sure Barry, it was just as hard in your day. The kids should shut up and stop drinking cappuccinos, right?)
This graph shows how property ownership is now the major driver of inequality:
Note the divergence on the right hand side (Click to enlarge)
The key is to look at how the lines used to be close together, and now aren’t. It was not ever-thus, in short. Not owning a home didn’t put you on a downward escalator for life.
Raising the White Paper flag
Like most, I don’t see much in the Housing White Paper that looks likely to address the under-supply of new homes in the UK.
Perhaps recent political events might if they curb migration and hence population growth – but then lower immigration could also reduce supply by depleting the workforce. (House builders are already complaining about a skills gap).
Maybe it’s time to think differently. If we can’t build enough extra houses, then perhaps those without houses could get a different kind of tax break, for instance.
It irks me enormously that friends see 10-20% capital gains tax-free growth each and every year on their homes while I face a huge bill if I sell various un-sheltered legacy holdings.
Shouldn’t investments be fungible, especially nowadays when it is so much harder to buy property? Maybe if you don’t own your home you should get a six-figure CGT allowance?
Okay, that’s an aspiring 1%-ers problem. The vast majority of millennials will struggle to even make a dent into the new £20,000 annual ISA allowance that’s coming in April.
Maybe renters could deduct their rent from their income tax bill? It sounds insane, but then crazy ailments may require outlandish treatments.
What the government should not do is row back on the tax changes hitting BTL. If anything it should speed them up. There’s no justification for a policy that actively encourages a minority to get richer, as per the inequality graphs above, while other citizens are locked out.
Oh, and before someone says it, I don’t think inheriting property wealth is the ideal solution. That just compounds the new feudalism of a property owning class and a rootless peasantry that we seem to be sleepwalking into.
Unless like me you want to start taxing inheritances at 90% or similar. And I know very few of you want to do that. 🙂
Here’s a few more property stories from this week:
Property owners get richer while everyone else gets poorer – Business Insider
This article about investing in the Donald Trump era is by former hedge fund manager turned author Lars Kroijer, an occasional contributor to Monevator. He also wrote Investing Demystified.
New US President Donald Trump is making headlines on an hourly basis. Our social media accounts are going crazy with comments about his presidency being a de facto coup or a one-way route to the apocalypse.
You may well be asking whether you should change your investment strategy as a result?
In short, the answer is perhaps – but probably not how you think.
In previous articles I have outlined how I consider it highly unlikely that the vast majority of investors can beat the markets – whether through active stock selection, market timing, or via picking the one out of ten actively investment funds that may manage to do so over a ten-year period.
I’ve also argued that for your equity exposure you should pick the broadest and cheapest index tracking exposure you can get your hands on, namely a world equity index tracker fund.
‘Just’ because Donald Trump is now President of the United States, that is no less true. You most likely couldn’t beat the markets before 9 November 2016. You still can’t. That hasn’t changed.
But what also hasn’t changed is that you can still expect to make returns of perhaps 4-5% above inflation. This estimate is based on over 200 years of history of equity returns in many states of the world.
However these average long-term expected returns will be volatile over the short-run. You can expect much higher returns some years, and terrible losses in others. And you can reasonably expect to be compensated in higher risk periods with commensurate higher expected returns, though there are no guarantees of this.
Okay, so even if in a Trump world we haven’t found a crystal ball, what can we do?
In my view, there are two main things we should focus on:
1. Evaluate whether the risk of the markets has changed enough that we should re-evaluate the risk levels of our portfolio.
2. Consider if the sudden change in the political landscape has changed our overall economic life enough that our risk profile should change as a result.
For the rest of this article I’ll explain how to do both things.
Market risk under President Donald Trump
You’ll find below a graph of the expected future risk of the US stock market. Without being too technical, it measures the expected standard deviation six months into the future. Since the index value is based on the implied volatility of equity options, it is a market price.
If you think you know the future volatility of the market better than this chart then you can get rich trading it. (Many try!)
There are many issues with this kind of chart, such as that the value itself is very volatile (so the risk changes a lot), the volatility doesn’t capture ‘fat tails’ 1, and it only looks six months into the future. All that said, it does give a good idea of future expected risk.
Look at the very volatile 2008/09 period circled in red, and compare it to the more recent period, also circled. What this tells us is that as momentous as the election of Trump was politically, in terms of market risk it hardly made a dent.
Because the election of Trump was a genuine surprise – Betfair had the probability of Trump becoming president at about 15% on election day – we can get a good sense of how much things shifted as a direct result of Trump’s election. (If Trump had been expected to win, then the impact of his presidency would already have been built into the market price.)
As things turned out, the equity market risk hardly moved.
Confused? Don’t be.
Just know that the expected risk of the stock market in the future did not change as a result of Trump, and so this factor alone should probably not cause you to change the risk profile of your portfolio.
Your risk with Trump as President
While the market risk has not changed as a result of the election, your personal risk might have. The overall market did not move hugely after the Trump election, but there are clearly some sectors and geographies that could be hugely impacted by his election.
You therefore need to understand how Trump’s election might affect your overall life.
For example, if you work at a Mexican company that exports most its products to the US, then a Hilary Clinton victory would clearly have been better news.
Similarly, imagine a scenario where you work in mid-level management at a BMW factory in the United States. You’re so confident in the company, you’ve previously invested most of your savings in BMW stock, your pension is guaranteed by BMW, and most people in the town you live in are also employed by BMW.
Now imagine Trump goes on one of his 3am Twitter rants:
“BMW are a bunch of foreign losers. Time to kick them out”.
Then imagine some hours later after Trump has slept a bit and had his morning coffee he tweets:
“I meant it. We are shutting them down”.
All hell breaks loose. BMW is down 50% and people start talking about the need to close the US operations. There’s a discussion about the risk of the BMW corporation defaulting on its debts.
Your whole economic life has been turned upside down because of Trump getting out of the wrong side of bed. To say you are overexposed to BMW would be a massive understatement. Your job, pension, savings, and house all correlate to the BMW corporation. You were guilty of putting all your eggs in the BMW basket and are now paying for it.
Very nasty – but less extreme versions of this example are equally worth avoiding.
Is Trump fighting for you or gunning for you?
So how do you know if sectors you are exposed to might be helped or hurt by Trump? Or by Brexit, incidentally, or any other big event?
Again, because Trump’s victory was a surprise we can see the market impact right after the election. If Trump’s hypothetical BMW Twitter rant had taken place before the election then you would expect BMW stock to be down a lot right after the election. That’s how you know.
It was not a surprise to see the Mexican Peso decline after Trump’s surprise win.
My advice? Sniff around. Understand your economic exposure and see how those sectors fared in the market’s mind after the election. Then look at how much Trump’s various statements and Tweets impact on how these things move.
Maybe it’s time for a change
If your investment portfolio consists of a world equity tracker combined with super low-risk government bonds, you will have broadly diversified away a lot of the sector and company-specific Trump risk.
But as illustrated by the BMW employee example we just saw, your individual non-portfolio exposures may still lead you to change the risk you feel you can afford to take in your investment portfolio.
For example, you may previously have felt quite relaxed about stock market risk, and employed a fairly bullish 75%/25% split between equities and bonds.
But after assessing your Trump-adjusted risk, you may feel a 50%/50% risk is appropriate.
This would not be because the markets have gone down in value, or up in terms of risk. Rather it would be because the sectors or geographies you are otherwise exposed to has changed your overall risk profile under Trump.
Has the appropriate risk level of your portfolio changed? (Click to enlarge)
Deciding how a Trump presidency might impact your overall economic life is far from a science. We don’t really know and can’t expect to be precise about it.
But you shouldn’t ignore the issue. The Trump presidency has the potential to be very consequential on your economic life.
There will be other shocks in the future, too. If you’re uncertain as to how much risk you should be taking in your portfolio, perhaps consider using a financial advisor to help you think through your exposures.
When hiring someone, make sure you don’t start paying them to actively outperform the market. Just as you probably can’t do that for yourself, they are likewise extremely unlikely to be able to outperform.
But they should be able to help you understand your overall economic life, how your risk profile may have changed – or even how you can protect yourself from being the mid-level BMW manager in the example above.
President Trump and you
I know it may feel odd that something can dominate the news like the Trump presidency and yet we are still not able to justify having a different perspective to that of the overall market.
However do think about how Trump might impact your job, sector, house, pension, insurance policies, and other things that contribute to your overall economic welfare – and then perhaps re-consider the risk of your portfolio as a result.
Below you’ll find a video that recaps the things I’ve discussed in this article. (You will find some other investing videos on my YouTube channel).
Well here we are, one month into the year of the people Taking Back Control. Isn’t it going well everyone?
In the UK the people have Taken Back Control and given it to a handful of Tory MPs. This right-wing minority of a centre-right party will now unilaterally establish how this country trades, regulates, and protects its citizens for generations.
What could possibly go wrong for the provincial masses 1 who voted for Brexit?
Of course, MPs have been told they’ll get a vote on the final terms of our departure from the EU. And as this week has shown they’ll be called traitors and enemies of the people if they don’t simply wave it through.
What part of democracy don’t I understand? That’s what Brexiteers have been shouting all week, as they lambasted anyone who questioned giving the government the right to pull us out of Europe before we’d reached any sort of national consensus on what Brexit should and should not entail.
An admittedly Herculean task, given the flat-out contradictory hopes and motivations of Leave voters, but that’s on a Leave voter’s conscience, not mine.
No, we voted out, that’s the litmus test for all routes forward. That’s the constant refrain. It’s like going to the doctor because you have an ingrown toenail and seeing your leg amputated. “Yes, but we’ve dealt with the toenail!”
Top trumped
Meanwhile in the US the people have Taken Back Control and given it to a thin-skinned autocrat who seems to be deliberately probing the system for its weakest links. He’s also openly scornful of the international institutions and alliances assembled in the past 70 years to keep the great powers in check and stave off total war, and the globalization that has helped take a billion people out of poverty in the past 20 years.
And he is not wasting any time in sorting out America’s problems!
On Friday he announced his administration would tear into the post-financial crisis regulations to get banks to lending again.
He literally – I shit you not – stated that he has “friends” who can’t borrow.
But let’s cut him some slack; you can see the lack of lending pretty clearly in this chart from the US Federal Reserve:
US commercial and industrial lending in billions since 2007.
I mean, I know it looks like total US commercial and industrial loans are now running about 30% higher than before the financial crisis.
But that’s just a fact!
You’ve get to get hip to alternative facts. You know, bogus funding claims written on buses, massacres that didn’t happen, nonsense theories that sound right but that are flatly wrong about the impact of immigration, trade, and so forth.
These distortions might all make for good sport in a world without nuclear weapons.
Unfortunately we don’t live in such a world. As with all his predecessors, a man follows the new President around day and night with the nuclear codes that enable him to begin World War 3 in about the time it takes to compose a Tweet.
Died in the wool
I would like to think those reasonable people who voted us out of Europe for reasons of sovereignty or even economics would at least now acknowledge the downsides of the alliance they made with nationalists, racists, and fascists to push them over the 50% mark.
Social media suggest they won’t. People are getting more entrenched, not less. There’s every chance it could get worse before it gets better.
I also don’t know if there are any Barry Blimps still reading Monevator. But there should be fewer than there were just through the natural attrition of the Leave voting cohort.
Here’s some – not to be taken hugely seriously – maths I shared with friends this week:
I’ve just been looking at Office for National Statistics data on deaths. I estimate at least 300,000 UK citizens have died since the Referendum.
Around 64% of over 65-year olds voted Leave, compared to just 29% of 18-24-year olds. Very few people die before 55, which is around the age that people started to favour Leave. Mostly the oldest Leave-ist voters die. Voter turnout was 72%.
Consider older people were more likely to turnout, assume people don’t change their vote as they get older, squint a bit, and I guestimate about 22,000 Leave voters are dying every month.
Brexit won by 1.2m votes. Within about five years Leave’s existing margin of victory will probably be dead, leaving us to lump it.
But wait – what about the new young? If we assume 70% or so would vote Remain and constant turnout, then Remain might win a Referendum within three years.
No wonder they want to trigger Article 50 and get us out in two.
(Caveat: All sums done in my head, your mileage may vary.)
Of course you can quibble with my assumptions.
For instance it’s possible young people are looking at the cabal of Conservative ministers heading off to Brussels to decide the future of the UK for themselves, at Nigel Farage chilling with Donald Trump, at the US refusing entry to its own legal residents for a period on a presidential whim and they’re thinking: “Hey, I don’t know what that guy is smoking but I want some of it!”
What do I know? I’m just a liberal elite snowflake.
Yes, I understand not every Leave voter was a member of the provincial masses. Perhaps you weren’t. But they are the ones I am talking about here. See how it works? Maybe I’ll write about another kind of Brexit voter later on. Who can tell![↩]
