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Weekend reading: Rebalancing works

Weekend reading

Good reads from around the Web.

One of the hardest things to explain to a new investor is the benefit of rebalancing asset allocations.

Until you’ve had the “aha!” moment, it can seem like madness to reduce your holdings of investments that are doing well, to buy stuff that’s losing you money.

And then, once you’ve had the “aha!” moment – well, then it’s hard to remember what it was like before you “aha!”-ed, making anyone who doesn’t yet get rebalancing seem a bit like a child who doesn’t yet get why they need to eat.

Enter Larry Swedroe, and his short article that proves again how the magic of rebalancing works. Swedroe cites numbers from an author I’ve never heard of, Jaques Lussier, and his book Successful Investing is a Process. Here’s rebalancing in action (US data, but it’s the same principle in the UK):

An investor begins in 1973 with a portfolio that is 50 percent stocks and 50 percent bonds. For the period ending in 2010, stocks outperformed bonds as they returned 9.8 percent versus 7.7 percent for bonds.

If the portfolio was never rebalanced, the ending portfolio would have had an allocation of 68 percent stocks and the annualized (compound) return would have been 8.9 percent.

Knowing that stocks beat bonds by 2.1 percent a year was the investor who never rebalanced better off?

My own experience tells me that most people would assume you would have been better off not rebalancing due to the much higher return of stocks. Yet, a rebalanced portfolio would have returned 9.5 percent, and done so with less volatility.

In other words, the diversification benefit was sufficient to overcome the 2.1 percent disadvantage in returns. During this period the annual correlation of stocks to bonds was close to zero (0.1).

Rebalancing feels bad in the short-term, but it works over the long-term.


From the blogs

Making good use of the things that we find…

Passive investing

  • Even the 2,000-year old Talmud’s asset allocation works – Mebane Faber
  • Market timing advice is just a coin flip – Rick Ferri
  • How not to prepare for the bear market in bonds [The GICs he cites are Canadian structured products. I’d suggest fixed interest cash deposits for diehard bond-averse UK investors] – Canadian Couch Potato

Active investing

Other articles

Product of the week: Foresight is launching a new solar farm fund paying a 6% yield. The Guardian has outlined the pros and cons.

Mainstream media money

Some links are Google search results – in PC/desktop view these enable you to click through to read the piece without being a paid subscriber of that site.1

Passive investing

  • A big guide to exchange traded funds (ETFs) – FT Adviser
  • Investment consultants cost billions yet add no value [Search result]FT

Active investing

  • Why you should buy Royal Mail shares via its IPO – Telegraph
  • Emerging markets cheap vs US [Graph at bottom]Research Affiliates
  • Jim Slater’s Zulu strategy still has legs… – This is Money
  • …and small caps have been delivering [Search result]FT

Other stuff worth reading

  • Merryn: Save more, but not into pensions [Search result]FT
  • Earn over £50,000? You may be able to claw back child benefit – Guardian
  • Forget exports: The UK should build more homes in London – Slate
  • Felix Salmon: The idiocy of crowd funding – Reuters
  • Inequality around the world – Economist

Book reader of the week: Have you joined the e-book revolution? You should – Bob Dylan is writing protests songs, free love is in the air, and there’s the prospect of exciting civil unrest! Okay, not really, but e-readers are convenient – and Amazon is currently offering its full-colour Kindle Fire 7″ for just £99, which is a discount of £30.

Like these links? Subscribe to get them every week!

  1. Reader Ken notes that: “FT articles can only be accessed through the search results if you’re using PC/desktop view (from mobile/tablet view they bring up the firewall/subscription page). To circumvent, switch your mobile browser to use the desktop view. On Chrome for Android: press the menu button followed by “Request Desktop Site”.” []

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{ 15 comments… add one }
  • 1 dearieme September 28, 2013, 3:52 pm

    I have been late to realise the advantage of rebalancing; I’ve come across it recently while reading up on the Harry Browne Permanent Portfolio after seeing that mentioned a few times on the MSE forums. I now plan to Impress My Wife by talking about “volatility harvesting”.

    Whether Mr Browne’s portfolio would suit us or not is rather a secondary issue – it’s the effectiveness of the rebalancing that’s striking.

  • 2 dearieme September 28, 2013, 5:33 pm

    “How not to prepare for the bear market in bonds”

    (i) I have some Index-Linked Gilts that are three years from maturity, held in an S & S ISA. I’m considering putting one third of the money into a 5-year Fixed Interest Gilt now, and then a second third in a year’s time, and then the last third in two year’s time. After a further year I’d sell the by-then two year old FIGs and buy another 5 year FIG. I would then have a “ladder” of Gilts with average time to maturity of about 3.5 years (so they won’t be very sensitive to interest rates) and I’ll be making a bit of “roll-down” on the money, as well as the coupon. I would view this lot as part of the “cash” in my portfolio.

    I’m comparing this policy with the alternative of inactivity; just letting the linkers mature and then deciding what to do. That’s “comparing” in the sense of ‘wondering what the devil to do’.

    P.S. I learnt about “roll-down” years ago, in the days when the PIMCO website carried lots of useful educational stuff on bonds. Perhaps it still does.

    (ii) Meantime, I’m wondering what to do about a holding in a bond fund in a personal pension. I’m considering switching 50% into an equity fund and then rebalancing every time a free switch is allowed.

  • 3 dearieme September 28, 2013, 5:43 pm

    It’s been useful typing up my last comment. I now see that my paragraph (i) scheme might be better started in a year’s time rather than now. That way (a) I shouldn’t have any selling costs on the last third of the ILGs, (b) I have a year more of protection against an unexpected rise in inflation rate, and (c) I have a year in which to see if there is any evidence of interest rates rising.

  • 4 Greg September 29, 2013, 2:06 pm

    Except that doesn’t make sense as otherwise the index would be getting more volatile over time, which it isn’t. The point is that it is self-normalising.

    Having said that. I have sympathy with the idea of non-cap weighting and combining holdings to minimise volatility in particular. When I have finished with my current endeavour, I’ll see if I can make a tool to analyse this.

    Of course, one doesn’t want to only consider volatility! Otherwise one would invest ins this: http://www.obliviousinvestor.com/roulette-etfs/ (I know it’s been up before, but it’s a funny article. :-D)

  • 5 The Investor September 29, 2013, 10:53 pm

    What’s more – it works within equity funds too – except with those scary trackers that get all out of balance as they hold on to risky assets in higher proportions as they grow in value.

    Very likely one of the secondary reasons (fees being the primary one, of course) that trackers beat a majority of active fund managers who do “obvious” things like reduce winners, and miss the multi-bagging gains from the likes of Apple and Vodafone in its pomp.

    The key takeway here though is not that rebalancing reduced risk (though it did) but that it increased return while reducing risk. That’s the bonus / free lunch of diversification.

    Readers who want to read some informed comment about market cap weighted trackers versus alternative methods might enjoy The Accumulator’s take from earlier this year.

  • 6 Nathan September 30, 2013, 11:43 am

    Thanks Investor, my IFA always confused me when he was waffling about rebalancing, I realise now that the bazillion funds he had my portfolio in kind of negated any rational approach.

    Investment advice always seems to devolve into endless discussion of complicated ‘optimal’ asset allocations and strategies.

    In reality I think things such as proper diversification, rebalancing, tax and fee minimisation, adding to and withdrawing from your portfolio, handling emergency cash and an understanding of risks are the things that actually matter.

    Perversely in my experience as a newb these are the things that are most difficult to find out about.

    The best source I found, was as dearieme intimated, the Harry Brown Permanent portfolio (which I first came across on Monevator IIRC). Even if the asset allocation is not your cup of tea, it does discuss the wider concepts to be considered in maintaining a stash of over the long term. The catch is you have to translate a bit from US to UK 🙂

  • 7 The Investor September 30, 2013, 12:53 pm

    @Nathan — Glad you found it useful! We’ve discussed everything you mention in the past, including — and I completely agree with you — the idea that rough allocations are fine and precise allocations are spurious. (Also see the mebane faber research I posted a few weeks ago, which he’s briefly recapped in the link above about the Talmud. The table shows all major broad diversified allocation strategies have done well long term).

    I accept it’s hard to find all this stuff in our archives, though hopefully the search bar in the sidebar can help. One area where books still have an edge over blogs, perhaps! 🙂

  • 8 Rob September 30, 2013, 1:17 pm

    The logic of rebalancing is irrefutable. However, executing it in practice is a lot harder than it might seem and it hinges on the time scale. Rebalancing as soon as a stock is a little o/wt or u/wt limits the opportunity.
    On the other hand, leave it too long and the anomaly might disappear as the Market catches up.

  • 9 The Investor September 30, 2013, 2:01 pm

    @Rob — Personally I think it’s easy in practice. Just rebalance every one or two or three years.

    What’s definitely hard is getting it *exactly right*. This is one of those areas of investing where we can’t say there is a precise frequency that is most beneficial. So you see ranges quoted from (from memory of manager David Swensen’s book) Yale rebalancing at least some of its assets every day to some of the passive investing gurus who say every year or two is fine, to those at the extreme who say rebalancing every five years is fine.

    There’s been plenty of research to try and find an ‘optimal’ rebalancing date, but nobody has and in any event I’d say any optimal strategy based on back-testing is subject to data mining risk (because we don’t know that the future will be exactly like the past — in fact we know it won’t be! 🙂 ).

    Pragmatically, once a year is fine for strategically lazy passive investors, I reckon. If using tracker funds at least some of the platform’s don’t even charge a penny for transfers, so it’s also free.

    I don’t think it matters if the market catches up sometimes. In that case the market has rebalanced for you. The prime aim of rebalancing is risk-control, so that’s fine. Superior returns from rebalancing are a happy byproduct over most periods — and the “free lunch” — but not the main aim. (Unless you’re trying to do something esoteric like ‘volatility harvesting’ mentioned above, which I suggest most passive investors don’t investigate as a strategy, but perhaps again enjoy as a byproduct 🙂 ).

  • 10 Paul Claireaux October 2, 2013, 12:37 pm

    The less frequently you rebalance then the more volatile your fund becomes – that’s fairly simple to prove.

    And yes, during times of euphoria – when certain stocks like ‘dot coms’ become ridiculously overvalued then trackers become very volatile too.

    That’s fine for long term regular savers with a long time horizon but NOT good for older folk who do not have the capacity for increased risk.

    A well managed active fund – and i don’t mean one of many closet trackers will look for value at these times. Look at Neil Woodford’s work for example – is that purely down to luck?

    As for charges – well a lot of these have been for commission and kickbacks to platforms – and that’s rapidly being consigned to history – the new world is about super clean share classes with strong active and risk managed funds available for around 50 to 65bps – check out Standard Life’s new platform

  • 11 The Investor October 2, 2013, 12:49 pm

    @Paul — Older savers will generally be better off reducing risk through a larger share of bonds (or cash), not through paying for active managers who have overwhelmingly failed to beat the market but who will charge higher fees for the privilege. But then you don’t like bonds either, do you?

    You must have a great Internet connection from your yacht moored off the Bahamas with your ability to generate alpha across multiple asset classes, as well as time the market? 🙂

    For the most of us mere mortals, pursuing a strategy of active funds that try to time the market (as you have previously advocated) and beat trackers (as you now advocate) has been a great way for the financial services industry to get rich over the years, at the expense of their clients.

    I happen to invest actively (through my own stock picking) but I am sure most people are best in passive funds, and I certainly don’t describe active investing in the no-brainer terms you do.

  • 12 Paul Claireaux October 2, 2013, 1:23 pm

    Your argument is – what I think is called – ad hominem. I prefer to stick to the issues rather than getting distracted with personal put downs. My genuine interest is in helping the ordinary investor to make more of his money without getting sucked into unnecessary risks.
    What I have stated above are facts as I understand them – if you disagree then state which part.
    With regards using bonds to reduce risk then – yes, you’re absolutely right – this does seem like a risky strategy right now. Are you really suggesting that?
    I think the issue here is whether any amateur fund manager (which I think is what we all are – including those financial advisers who create their own ‘homegrown’ portfolios using trackers and bond funds) can seriously manage a portfolio for income or for growth and control against downside risk (in equities or bonds) as well as a good active management group like Invesco perpetual or M&G.
    I’d say not.
    But if you have evidence to the contrary then let’s see it – but please let’s not hear about how many active funds underperform the index again! Of course most of them do because 1) the data often assumes full retail cost – which is not a fair comparison to a nil commission bearing tracker and 2) because most of them are in fact ‘closet’ trackers – as you’ve rightly pointed out.
    Let’s not forget that 100% of trackers underperform the market either! (or if they don’t then they’re not doing what they should!)
    What’s really odd is all this talk of trackers followed by your statement that you ‘stock pick’ for yourself – something a contradiction isn’t it? Personally I use both tracker and active funds but I don’t fool myself that either is a panacea.
    I guess we’ve exhausted our debate here so I’ll say goodbye for good this time and get my book finished.
    All the best.

  • 13 The Investor October 2, 2013, 2:10 pm

    @Paul — I am fed up with arguing with you. I didn’t create this blog to argue with people. I am also fed up with pundits (not particularly yourself but just widely across the Web) who talk about things like CAPE valuation and market timing and how one simply has to pick the right funds, when all the evidence is private investors cannot do this, hugely reduce their returns trying to do so — and when the pundits provide no evidence that they can do so themselves.

    In this world what I say (which is evidence based when it comes to the merits of passive investing, and which is back-searchable on the blog) can be roundly criticized, while what they say (which is just flatly stated, defies all evidence, and has to be taken on trust) is apparently equally weighted.

    This has been going on since 2009 when other people (not you, from memory) were arguing it was mad to buy shares because of CAPE this, or gold that. Great call. People lose money, repeatedly, because of this sort of thing.

    It’s wearying to fight this tide of misinformation (as I see it) on my own blog. You have the entire rest of the Internet to promote your views in.

    I have repeatedly stated the facts as I see them to you over comments we’ve had in the past 1-2 years.

    There is masses of evidence that diversified rebalanced passive portfolios deliver long-term excellent results for investors. For just one recent example see Mebane Faber’s work that I referenced here, which compiles data since the 1970s:


    Long-term returns of 9.5% to 10.5% will do most people just fine. This is just one of the many studies out there. Sure future returns may be higher or lower than that. But I will bet folding money that ad hoc attempts to do better by the average person will do worse.

    I accept the yacht comment was a jibe. The context is above.

    I choose to invest my own money actively, knowing the incredible risks and hurdles. Let me assure you that the last thing I think is that I am certain to do better, especially on a risk-adjusted basis. But it is my choice.

    Good luck with your book. Please be aware I am not going to argue any more. You’ve had your say and I’ve had mine.

  • 14 Paul Claireaux October 2, 2013, 2:37 pm

    Okay that’s fine
    And please don’t shoot the messenger but Mebane is keen on CAPE too – http://www.mebanefaber.com/2013/04/16/countries-sectors/

  • 15 The Investor October 2, 2013, 2:42 pm

    Paul, as I’ve said before in these endless debates, I watch CAPE too. I think about it. I just don’t think it’s a silver bullet.

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