(PUB) Investing 2016

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Fund Family Shareholder Association

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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,

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

Easy on Paper, Not So Easy To Do

Trades

Avg.

Mos.

Btwn.

Trades

Fewest

Mos.

Btwn.

Trades

Most

Mos.

Btwn.

Trades

Terminal

Value of

$100

Annualized

Return

Basis

Diff.

MCL

No rebalancing

0 — — — $1,067

8.50% -34.5%

Rebalancing on a 10% spread 16 22

99 $1,020

8.33% (17) -28.4%

Rebalancing on a 5% spread

50 $1,045

8.42% (8) -26.9%

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

Lots of Work,

Little Payoff

No Rebalancing

10% Rebalancing

5% Rebalancing

12/87

12/91

12/95

12/99

12/03

12/07

12/11

12/15

$200

$400

$600

$800

$1,000

$1,200

Note: Threshold-based rebalancing strategies.