(PUB) Investing 2016

The Independent Adviser for Vanguard Investors

•

February 2016

•

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800-211-7641

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

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

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

Rebalancing’s Benefits Are Minimal

Semiannual

rebalancing

———— ROLLING RETURNS ———— Terminal

Value of

$100

Annualized

Return

Basis

Pt.

Diff.

MCL

1-month 1-year 3-year

5-year

Best

7.3% 30.2% 20.6% 17.9%

Average

0.7% 8.7% 8.6% 8.4%

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%

Average

0.7% 8.8% 8.7% 8.5%

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%

Average

0.7% 8.7% 8.6% 8.4%

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%

Average

0.7% 9.1% 8.8% 8.4%

Worst

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

8.50% — -34.5%

Note: Multiyear returns are annualized.

Rebalancing Is

About Risk

12/87

12/91

12/95

12/99

12/03

12/07

12/11

12/15

Note: Calendar-based rebalancing strategies.

Semiannual

Annual

Every 3 Years

Never

$200

$400

$600

$800

$1,000

$1,200