Dumb Idea: Rebalancing Boosts Returns

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avbferry
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Dumb Idea: Rebalancing Boosts Returns

Post by avbferry »

Just wondering if you guys have any thoughts on this?

http://www.forbes.com/sites/baldwin/201 ... r=yahootix

Based on all the material that I have been reading previously, rebalancing seems to be recommended.

Thanks.
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Re: Dumb Idea: Rebalancing Boosts Returns

Post by Toons »

Rebalance once a year :happy
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Re: Dumb Idea: Rebalancing Boosts Returns

Post by Sam I Am »

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Re: Dumb Idea: Rebalancing Boosts Returns

Post by The Wizard »

Rebalancing is done to Control Risk. All Bogleheads know this.
Plus there are a bunch of different ways to rebalance; don't have to go all the way back to target. Some algorithms allow a few percent hangoff in the prevailing direction...
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Re: Dumb Idea: Rebalancing Boosts Returns

Post by larryswedroe »

Sam

First, in a world without frictions (costs) rebalancing should be done DAILY, otherwise you have allowed the MARKET to control your AA and thus the risk of your portfolio which makes no sense whatsover.

Second, because there are frictions, and even time spent has value, it makes sense to create rules about how much you should allow your portfolio to drift away from your targets.But that obviously has nothing to do with TIME intervals, but drift from your target.

Third, rebalancing can be expected to add to returns under two conditions; you have assets with similar expected returns and you have RTM. But if you have stocks and bonds which don't have similar expected returns than each time you rebalance from stocks to bonds you are lowering the expected return of the portfolio. Similarly when you sell SV to buy LG the same thing is happening.

So the example given with rebalancing leaving you with lower ending outcome should have been expected. If the returns end up similar, rebalancing will improve returns. And the lower the correlation and the more volatile the components the greater will be the differential.

Finally, what is referred to as the rebalancing bonus is not higher portfolio return--it's that the portfolio's return being greater than the weighted average of it's component's returns

Hope that helps

Larry
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Re: Dumb Idea: Rebalancing Boosts Returns

Post by livesoft »

I only rebalance at the market high and the market low for the year. I don't know about everyone else, but that works rather well for me.
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Re: Dumb Idea: Rebalancing Boosts Returns

Post by john94549 »

You can do the math yourself (I did). Re-balancing three times during the swoon of 2008 (each S+P 500 20% leg downward) worked as one would expect.
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Re: Dumb Idea: Rebalancing Boosts Returns

Post by Blues »

livesoft wrote:I only rebalance at the market high and the market low for the year. I don't know about everyone else, but that works rather well for me.
LOL! :oops: I knew I should've bought the same watch as you!

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Re: Dumb Idea: Rebalancing Boosts Returns

Post by tadamsmar »

Reblancing typically decreases your expected returns for the typical AA.

It's possible but uncertain whether rebalancing increases your risk-adjusted returns. As the article points out, nobody is arbitraging the practice. Rebalancing too often might decrease risk-adjusted returns.

It's not dumb because rebalancing is done to keep your risk from increasing over the long run. If you never rebalance then your stocks would most likely grow to take an increasing allocation of your nest egg vs your bonds. But you don't have to rebalance very often to keep this in check.
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Re: Dumb Idea: Rebalancing Boosts Returns

Post by ObliviousInvestor »

William Sharpe has a paper on the topic of rebalancing that you might find interesting: http://www.stanford.edu/~wfsharpe/retecon/wfsaaap.pdf
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Re: Dumb Idea: Rebalancing Boosts Returns

Post by YDNAL »

avbferry wrote:Just wondering if you guys have any thoughts on this?

http://www.forbes.com/sites/baldwin/201 ... r=yahootix

Based on all the material that I have been reading previously, rebalancing seems to be recommended.

Thanks.
Pick a different time frame, though, and you get a different result. Analysts at Vanguard looked at stock and bond performance over the 74 years through 2009 and found this: Someone who bought 60% stocks and 40% bonds at the start, and then did nothing, would have averaged a 9.1% annual return; someone who rebalanced to 60/40 every month would have averaged only 8.5%.
People need something to write, so they write.

1. Who rebalances monthly? [unless necessary to maintain portfolio risk]

2. If/when I rebalance, it is not to "boost returns" but to control risk. And, I use rebalancing Bands to allow for latitude.
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Re: Dumb Idea: Rebalancing Boosts Returns

Post by Matigas »

Mr. Bogle refers to rebalancing and the debate about it as 'noise'.
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Re: Dumb Idea: Rebalancing Boosts Returns

Post by grayfox »

ObliviousInvestor wrote:William Sharpe has a paper on the topic of rebalancing that you might find interesting: http://www.stanford.edu/~wfsharpe/retecon/wfsaaap.pdf
Interesting paper. from page 21
(12)Asset Allocationt = f(Investor Characteristicst,History<=t,EconomicTheoryt, MarketValuest)

The inevitable conclusion is that an investor’s asset allocation, expressed in the traditional manner as percentages of total value in each asset class, should change over time to reflect changing market values, even if the investor’s characteristics are unchanged. This is the key tenet of this paper.

Importantly, such an approach may not require substantial transactions over and above those associated with reinvesting dividends, interest payments and other cash received from security issuers. Moreover, there is no reason to expect that it will involve selling relative winners and buying relative losers, as must be done to conform with a traditional asset allocation policy.
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Re: Dumb Idea: Rebalancing Boosts Returns

Post by Random Musings »

livesoft wrote:I only rebalance at the market high and the market low for the year. I don't know about everyone else, but that works rather well for me.
However, it's a shame that your recommendations for rebalancing shows up in your years-end newsletter edition.

RM
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Re: Dumb Idea: Rebalancing Boosts Returns

Post by Rick Ferri »

More risk = more return. That's why the portfolio that wasn't rebalanced earned more.

What the author fails to mention is that a 60/40 portfolio that was not rebalanced for 70 years would have been over 90% in equity going into the bear market starting in 2007.

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Re: Dumb Idea: Rebalancing Boosts Returns

Post by nisiprius »

If you put $6,000 in Vanguard Five Hundred Index Fund at the start of 1990 (Total Stock not yet having launched), and $4,000 in Vanguard Total Bond Index Fund--i.e. 60%/40%--ten years later you'd have had $31,601 in Five Hundred Index and $8272 in Total Bond, i.e. just about 80%/20%.

The difference in risk between 60%/40% and 80%/20% is meaningful, so, during that fairly extreme decade, it was probably a good idea to rebalance a couple of times just to stick to plan and keep risk at the intended level. So, occasionally rebalancing for risk control is probably "necessary," but you sure don't need to do it very often.

As for the rebalancing bonus: during 2008-2009, I was pretty terrified and didn't quite have the courage to rebalance in the sense of placing orders. But quite a lot of my holdings were in Vanguard Balanced Index Fund which kept rebalancing for me. When it was over, I felt good thinking about all the "buying low" the fund had done for me--until I actually checked. I discovered that if investor A put $10,000 in Balanced Index and waited until it had dipped and recovered to $10,000, while investor B put $6,000 in Total Stock and $4,000 in Total Bond and never rebalanced, the overall result was virtually identical. Less than $100 more for Balanced Index, IIRC.

During 2008-2009, rebalancing actually magnified the dip on the way down, as rebalancing constantly threw good money after bad--and then magnified the climb on the way up. Overall, it came out just about the same. And the risk magnification, the "rebalancing suckage on the way down" as it might be called, wasn't terribly extreme. It just didn't really make a lot of difference.

The topic is debated endlessly but I think it's reasonably well understood at this point that continuous or very frequent rebalancing, as in a balanced index fund, doesn't add to return. To get a rebalancing bonus requires mean reversion, and it also requires that rebalancing be done at the right time interval to capture that mean reversion. If you believe the assets are mean reverting over a period of X years, you should rebalance only every X years. But there is debate about how strong or reliable mean reversion really is. All that stuff falls in the great hazy area of "there might be something to it, and a lot of smart people seem to think so, but, then again, maybe not."

The mental trap is that one mentally imagines timing the market, i.e. rebalancing in February 2009. But that isn't really what happens. If you rebalance periodically, the rebalancing is just going to happen at sort of irrelevant times. If you go in for "opportunistic rebalancing," that's not really rebalancing, that's market timing by another name.

I think Baldwin is overheating his rhetoric with "dumb idea" and "balderdash." But if I had to choose between "balderdash" and "magic formula for automatically buying low and selling high," I'd go with "balderdash."
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Re: Dumb Idea: Rebalancing Boosts Returns

Post by leonard »

Rebalancing controls risk by controlling your AA. It isn't intended to boost return.
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Re: Dumb Idea: Rebalancing Boosts Returns

Post by rkhusky »

nisiprius wrote: it also requires that rebalancing be done at the right time interval to capture that mean reversion.
You get a rebalancing bonus if your algorithm happens to have you buying stocks at a dip and/or selling at a peak. Although you may get lucky occasionally (e.g. if there is a major one-day correction), most of the time you are going to miss the bottom of the big drops and the peaks of the big gains.
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Re: Dumb Idea: Rebalancing Boosts Returns

Post by rustymutt »

I rebalance when ever the heck I like. Works better for me that way.
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Re: Dumb Idea: Rebalancing Boosts Returns

Post by Index Fan »

I seem to remember William Bernstein in The Investor's Manifesto saying that rebalancing every 2 or 3 years worked well (I hope I'm remembering that right).
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Re: Dumb Idea: Rebalancing Boosts Returns

Post by john94549 »

I was glad to see someone else (namely, nisiprius) did roughly the same calculation I did, and arrived at the same result.

I don't know about others, but (for me) it was counter-intuitive.
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Re: Dumb Idea: Rebalancing Boosts Returns

Post by livesoft »

OK, lots of what I would call a Defeatist Attitude on rebalancing in this thread. I would challenge Bogleheads to come up with a way of rebalancing that is meaningful.

Opportunistic rebalancing (aka market timing) is one way perhaps. I would say that RBDs is another way (at least when to rebalance into equities).
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Re: Dumb Idea: Rebalancing Boosts Returns

Post by Rick Ferri »

People often ask me if there is a best method. My answer is always the same. The best method is the one you’re able to implement religiously without emotion. After that, the method that results in the best risk-adjusted return going forward is more luck than science. Here is a recent article I wrote in the subject:

Choices in Portfolio Rebalancing

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Re: Dumb Idea: Rebalancing Boosts Returns

Post by SnowSkier »

One question on rebalancing approaches...

The "Range Rebalance to a Tolerance Band" approach in the paper by Gobind Daryanini looks very interesting. Any feedback or additional info on this approach?

For reference:
1. Here's the paper: http://www.tdainstitutional.com/pdf/Opp ... yanani.pdf
2. And, here's an old bogleheads thread (Jan 2008) on this method: Opportunistic Rebalancing: A New Paradigm
Note that in this thread, Gobind Daryanini weighs in with additional guidance beyond what is contained in the paper.

It appears that using this approach would involve (a) setting rebalance Action limits at 80% and 120% of one's allocation target for each asset class or subclass (e.g. TSM, SmallCapValue, REIT, TISM, Bonds), (b) checking every week or so, and then (c) rebalancing back to 90% or 110% of the allocation target when the action limits are triggered.

As an example to check my understanding of how to apply this: If I'm targeting an asset class to be 20% of my portolio, my rebalance action limits would then be 16% and 24%. And the tolerance band would be 18% & 22%. So, if I hit 16%, I rebalance back to 18% (or more, if needed to get all asset classes within their tolerance band).

Looks very interesting, and I like the formulaic approach to help with behavior/emotion. I see a lot of pros, what cons am I missing? Also, any info on this method being applied during or after 2008?
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Re: Dumb Idea: Rebalancing Boosts Returns

Post by livesoft »

First, I will say that hard numbers are unimportant. Second, the opportunistic rebalancing is not much different than Larry Swedroe's 5/25 rebalancing. Perhaps the only difference is that one explicitly looks often to see if a rebalancing band has been triggered.

Some folks on the forum say they use 5/25, but they don't look that often, so that if a band is triggered and then things change before they notice, they will not even know that they should've rebalanced. I suppose that's fine.

Personally, I like 5/25, but also like to see something that suggests that momentum will change. By that, I mean that if stocks are going up, what signals a change in going up and if stocks are going down, what signals a change in going down. If one is using 5/25, then these momentum changes do not have to be perfect and you will not be whipsawed. For example, if you use RBDs as a signal, there were only 2 RBDs in all of 2012, so no chance of being whipsawed.

Let me give folks an example of an algorithm to rebalance into more equities that they can backtest: Suppose one uses 5/25 and sees that their band is triggered but not by an RBD. Rather than rebalance at that time, they wait for the next RBD and rebalance then. However, if the 5/25 band was triggered by an RBD, they go ahead and rebalance at that time.
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Re: Dumb Idea: Rebalancing Boosts Returns

Post by Akiva »

avbferry wrote:Just wondering if you guys have any thoughts on this?

http://www.forbes.com/sites/baldwin/201 ... r=yahootix

Based on all the material that I have been reading previously, rebalancing seems to be recommended.

Thanks.
You should rebalance to stay close to your target allocation. If you don't rebalance, your allocation will drift arbitrarily. Furthermore, hypothetically speaking, if not rebalancing didn't cause your allocation to drift, then you'd *still* want to rebalance because rebalancing causes your geometric returns (CAGR) to be closer to your arithmetic returns. Given that this is a significant drag on actual stock returns vs. reported returns, that alone makes rebalancing worth it. (If you are curious about this, you can look up formulas that will tell you how much your CAGR will change based on the rebalancing given the volatilities and correlations of the things in your portfolio.)
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Re: Dumb Idea: Rebalancing Boosts Returns

Post by richard »

livesoft wrote:I only rebalance at the market high and the market low for the year. I don't know about everyone else, but that works rather well for me.
I prefer Will Rogers' advice, "buy some good stock and hold it till it goes up, then sell it. If it don't go up, don't buy it."
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Re: Dumb Idea: Rebalancing Boosts Returns

Post by rkhusky »

livesoft wrote:First, I will say that hard numbers are unimportant. Second, the opportunistic rebalancing is not much different than Larry Swedroe's 5/25 rebalancing. Perhaps the only difference is that one explicitly looks often to see if a rebalancing band has been triggered.

Some folks on the forum say they use 5/25, but they don't look that often, so that if a band is triggered and then things change before they notice, they will not even know that they should've rebalanced. I suppose that's fine.

Personally, I like 5/25, but also like to see something that suggests that momentum will change. By that, I mean that if stocks are going up, what signals a change in going up and if stocks are going down, what signals a change in going down. If one is using 5/25, then these momentum changes do not have to be perfect and you will not be whipsawed. For example, if you use RBDs as a signal, there were only 2 RBDs in all of 2012, so no chance of being whipsawed.

Let me give folks an example of an algorithm to rebalance into more equities that they can backtest: Suppose one uses 5/25 and sees that their band is triggered but not by an RBD. Rather than rebalance at that time, they wait for the next RBD and rebalance then. However, if the 5/25 band was triggered by an RBD, they go ahead and rebalance at that time.
If you never see a RBD, you may never rebalance. You may want a second band (or fixed time period), such that if it is breached, you rebalance even without a RBD.
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Re: Dumb Idea: Rebalancing Boosts Returns

Post by learning_head »

Rick Ferri wrote:People often ask me if there is a best method. My answer is always the same. The best method is the one you’re able to implement religiously without emotion. After that, the method that results in the best risk-adjusted return going forward is more luck than science. Here is a recent article I wrote in the subject:

Choices in Portfolio Rebalancing

Rick Ferri
Hi Rick, when reading articles like this, I am always interested in how these compare to daily rebalancing implemented by LifeStrategy funds. Is there a large difference between risk-adjusted returns of LifeStrategy-like funds (in their "new" shape of using 3/4 underlying vanguard funds) vs other methods? (Clearly risk-wise, LS[-like] funds will be more on point, but does this "sacrifice" any return?)
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Re: Dumb Idea: Rebalancing Boosts Returns

Post by Rick Ferri »

Lifestrategy funds that rebalancing daily rely on cash inflows and outflows from fund investors as well as dividends and interest. An individual couldn't do this with a diversified index fund or ETF portfolio. Does daily rebalancing within a fund make a difference? Perhaps, but so do expense ratios. Vanguard Lifestrategy funds are composed of investor class shares, so you pay higher fees than Admiral shares or ETF shares. Net, net, I'm not convinced there is any real benefit.

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Re: Dumb Idea: Rebalancing Boosts Returns

Post by sapocanhoto »

I made a spreadsheet a while back to see how rebalancing affects returns, I used the numbers from TSP starting 2 Jun 2003 going through 18 Mar 2013. (2 Jun 2003 was the oldest data they had on the TSP website) The percentages are total return, not annualized.

For a portfolio of 60% C and 40% F:

No balancing 82.0%
Daily rebalancing 91.7%
Rebalancing when .5% off AA 91.3%
Rebalancing when 1% off AA 90.4%
Rebalancing when 2% off AA 89.5%
Rebalancing when 3% off AA 89.3%
Rebalancing when 5% off AA 86.7%
Rebalancing when 8% off AA 92.9%

For a portfolio of 40% C, 20% S, 20% I, and 20% F:

No balancing 108.1%
Daily rebalancing 116.4%
Rebalancing when .5% off AA 116.2%
Rebalancing when 1% off AA 115.2%
Rebalancing when 2% off AA 114.1%
Rebalancing when 3% off AA 114.0%
Rebalancing when 5% off AA 115.4%
Rebalancing when 8% off AA 108.1%

At least during that time period, more frequent rebalancing usually increased returns, but in the case of a 60/40 portfolio the best return was rebalancing when AA deviation exceeds 8%. I guess it all depends the volatility and magnitude of the market swings, which if you could predict you wouldn't need a rebalancing strategy anyway.
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Re: Dumb Idea: Rebalancing Boosts Returns

Post by lostcowboy »

A oldie but goodie, Practical Formulas for Successful Investing by Lucile Tomlinson. She talks about both fixed ratio plans and variable ratio plans.
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Re: Dumb Idea: Rebalancing Boosts Returns

Post by telemark »

You can read a sensible discussion of this here. Or just skip to the end, where it says
A better assumption is to see rebalancing generally as a risk-management tool, first and foremost, with the potential to elevate returns.
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Re: Dumb Idea: Rebalancing Boosts Returns

Post by LadyGeek »

The wiki has background info: Rebalancing

It references the Vanguard publication mentioned in the article: Best Practices for Portfolio Rebalancing and this one: Portfolio Rebalancing in Theory and Practice:
Vanguard wrote:To ensure that a portfolio’s risk and return characteristics remain consistent over time, a portfolio must be rebalanced... Based on reasonable expectations about return patterns, average returns, risk, and correlations, we conclude that for most broadly diversified stock and bond fund portfolios, annual or semiannual monitoring, with rebalancing at 5% thresholds, produces an acceptable balance between risk control and cost minimization.
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Re: Dumb Idea: Rebalancing Boosts Returns

Post by mlewis »

larryswedroe wrote:Sam

First, in a world without frictions (costs) rebalancing should be done DAILY, otherwise you have allowed the MARKET to control your AA and thus the risk of your portfolio which makes no sense whatsover.



Larry

I disagree.
This might be true if your only goal is to control risk and not to also hope for some kind of rebalancing bonus. Also, what if you are rebalancing asset classes with similar risks?

Daily rebalancing mutes the rebalancing bonus, to the extent it will appear.

From Bill Bernstein:
"There is overwhelming evidence that there is short-term persistence in asset class returns, so it is a good idea not to be too hasty pulling the trigger."
http://www.efficientfrontier.com/ef/100/rebal100.htm

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Re: Dumb Idea: Rebalancing Boosts Returns

Post by magician »

Rick Ferri wrote:More risk = more return.
Would that this were true.
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Re: Dumb Idea: Rebalancing Boosts Returns

Post by midareff »

Index Fan wrote:I seem to remember William Bernstein in The Investor's Manifesto saying that rebalancing every 2 or 3 years worked well (I hope I'm remembering that right).
and Otar says every four years at the end of the Presidential Election cycle.
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Re: Dumb Idea: Rebalancing Boosts Returns

Post by zaboomafoozarg »

Blues wrote:
livesoft wrote:I only rebalance at the market high and the market low for the year. I don't know about everyone else, but that works rather well for me.
LOL! :oops: I knew I should've bought the same watch as you!

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Re: Dumb Idea: Rebalancing Boosts Returns

Post by larryswedroe »

mlewis

Simple answer is this: IF today you decide to be 60/40 and tomorrow market moves you to 55/45 what logic is there to allow the market to change your AA if your assumptions about ability, willingness and need to take risk have not changed. The answer is obviously no logic. Thus you should rebalance daily if there are no frictions. Which is exactly what endowments like Yale do with cash flows

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Re: Dumb Idea: Rebalancing Boosts Returns

Post by rmelvey »

Rebalancing can boost returns by bringing your portfolio's geometric return closer to the weighted average of the arithmetic returns of its components. I wrote about this concept in a blog post:
http://www.stableinvesting.com/2013/04/ ... demon.html
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Re: Dumb Idea: Rebalancing Boosts Returns

Post by mlewis »

larryswedroe wrote:mlewis

Simple answer is this: IF today you decide to be 60/40 and tomorrow market moves you to 55/45 what logic is there to allow the market to change your AA if your assumptions about ability, willingness and need to take risk have not changed. The answer is obviously no logic. Thus you should rebalance daily if there are no frictions. Which is exactly what endowments like Yale do with cash flows

Larry
It all comes down to the strategy you want to follow. That may be one method. But there are others, and rebalancing is not just about risk.

Your strategy might justifiably be: Be 50/50 Europe/Pacific on friday (as one part of the portfolio), and let it deviate for 2 years as the market dictates. After that, rebalance. There are many reasons to wait besides just friction costs.

malcolm
WhiskeyJ
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Re: Dumb Idea: Rebalancing Boosts Returns

Post by WhiskeyJ »

larryswedroe wrote: Third, rebalancing can be expected to add to returns under two conditions; you have assets with similar expected returns and you have RTM. But if you have stocks and bonds which don't have similar expected returns than each time you rebalance from stocks to bonds you are lowering the expected return of the portfolio. Similarly when you sell SV to buy LG the same thing is happening.
I made the decision a few years ago of getting into a sector rebalancing strategy, assuming all sectors had an equal expected return. I equal weighted all 10 vanguard ETF sectors with 50% of an equity allocation (with remaining 50% in total market, total international, and emerging markets). Then I realized I'm essentially overweighting small cap stocks based on VTI sector profile. https://personal.vanguard.com/us/funds/ ... IntExt=INT

I've been gradually exiting this strategy shifting to a simpler portfolio. However, there are no trading costs and virtually no tax implications. So who knows, if there are similar actual returns between the 10 asset classes and low correlation along the way, I suppose this could turn out to be a lucky experiment/experience.
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Re: Dumb Idea: Rebalancing Boosts Returns

Post by larryswedroe »

malcolm
Sorry --please explain why if day 1 you decide on 60/40 as the right amount of risk for you, and the next day no assumptions have changed but your AA has changed what logic are you using to allow the market instead of you to determine your AA. There isn't any. Any other argument is basically about trying to find a way to get higher returns. Longer rebalancing periods simply take on more risk on average (the riskier higher expected returning assets tend to outperform of course) and they are momentum plays.

Now in real world we do have frictions and don't have the cash flows that institutions do so we should not rebalance daily but should always rebalance with new cash flows (one way to do this is to not reinvest divs and distributions but take in cash and rebalance). So you should consider taxes and trading costs to find optimal rebalancing and it should have NOTHING to do with time frame, but distance from your target, cost of trade, tax lots used, and volatility of the asset class.

Best wishes
Larry
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Re: Dumb Idea: Rebalancing Boosts Returns

Post by YDNAL »

mlewis wrote:It all comes down to the strategy you want to follow. That may be one method. But there are others, and rebalancing is not just about risk.
Malcolm,

Rebalancing "is" just about risk - especially more so at the Equity (riskier)/Fixed (less risky) level.
mlewis wrote:Your strategy might justifiably be: Be 50/50 Europe/Pacific on friday (as one part of the portfolio), and let it deviate for 2 years as the market dictates. After that, rebalance. There are many reasons to wait besides just friction costs.
At this level of 50/50 Equity risk by Region (Europe/Pacific), your "strategy" must be solidly grounded on something. Now, are market influences to be allowed to dictate and influence this "something" ?
Landy | Be yourself, everyone else is already taken -- Oscar Wilde
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Re: Dumb Idea: Rebalancing Boosts Returns

Post by linguini »

I don't feel like doing out the math, but I think it's actually true that if you had two assets that had an asymptotically identical expected increase over the long term (eg, Pacific equity and European equity each have average growth of 7% long run) and performed somewhere in between an uncorrelated random walk and a mean-reverting tendency (eg, if you can't tell the ratio of price of Pacific equity to price of European equity on any given day but in the long run they tend toward the same ratio of Pacific being worth half of European), rebalancing would increase average expected return. If that's the case, it's plausible that rebalancing between certain asset classes could increase average expected return, eg if you expect that returns within a particular sector or market in the long run tend to have some "sticky" price ratios rather than perform a 100% random walk and will tend to revert toward those ratios at least in the medium term. For this to happen, all you need is for panics and bubbles to cause different equity markets to have a tendency for "overreach" in the short term and see corrections in the medium term, so that when you are rebalancing between your asset classes, you end up on average less invested in assets that are in bubbles and more invested in assets that are undervalued during panics. I find it plausible that there is such a mean reversion tendency and that equity markets are prone to bubbles and undervaluation. For example, we've seen plenty times that when stock market indices plummet really quickly, they tend to come back up very quickly as well, so it seems plausible to me that there is some aspect of mean reversion at least for equities overall and this could be true between sectors or regions as well. It violates the efficient markets hypothesis, but not in a way that seems terribly far-fetched to me. To take advantage of it, just lock in an asset allocation based on current sector and regional weightings, rebalance every few months for twenty years based on the current asset allocation, then lock in a new asset allocation that brings you closer to the current sector and regional market weightings to capture long term changes.

On the other hand, I would not follow this strategy myself and I wouldn't give it as investment advice, so take it with a grain of salt. While I believe in the mean-reverting tendency for equities as a whole (and thus that if you choose an asset allocation of stocks to bonds at the beginning and then stick to it you will on average do better than choosing to make an initial investment with a higher ratio of bonds because you expect stocks to grow and then never rebalancing in such a way that you expect to have an equivalent weighted asset allocation over the investment period), I am less convinced this is true between different equity sectors and regions, so I would not engage in this strategy.
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Re: Dumb Idea: Rebalancing Boosts Returns

Post by ResearchMed »

linguini wrote:I don't feel like doing out the math, but I think it's actually true that if you had two assets that had an asymptotically identical expected increase over the long term (eg, Pacific equity and European equity each have average growth of 7% long run) and performed somewhere in between an uncorrelated random walk and a mean-reverting tendency (eg, if you can't tell the ratio of price of Pacific equity to price of European equity on any given day but in the long run they tend toward the same ratio of Pacific being worth half of European), rebalancing would increase average expected return. If that's the case, it's plausible that rebalancing between certain asset classes could increase average expected return, eg if you expect that returns within a particular sector or market in the long run tend to have some "sticky" price ratios rather than perform a 100% random walk and will tend to revert toward those ratios at least in the medium term. For this to happen, all you need is for panics and bubbles to cause different equity markets to have a tendency for "overreach" in the short term and see corrections in the medium term, so that when you are rebalancing between your asset classes, you end up on average less invested in assets that are in bubbles and more invested in assets that are undervalued during panics. I find it plausible that there is such a mean reversion tendency and that equity markets are prone to bubbles and undervaluation. For example, we've seen plenty times that when stock market indices plummet really quickly, they tend to come back up very quickly as well, so it seems plausible to me that there is some aspect of mean reversion at least for equities overall and this could be true between sectors or regions as well. It violates the efficient markets hypothesis, but not in a way that seems terribly far-fetched to me. To take advantage of it, just lock in an asset allocation based on current sector and regional weightings, rebalance every few months for twenty years based on the current asset allocation, then lock in a new asset allocation that brings you closer to the current sector and regional market weightings to capture long term changes.

On the other hand, I would not follow this strategy myself and I wouldn't give it as investment advice, so take it with a grain of salt. While I believe in the mean-reverting tendency for equities as a whole (and thus that if you choose an asset allocation of stocks to bonds at the beginning and then stick to it you will on average do better than choosing to make an initial investment with a higher ratio of bonds because you expect stocks to grow and then never rebalancing in such a way that you expect to have an equivalent weighted asset allocation over the investment period), I am less convinced this is true between different equity sectors and regions, so I would not engage in this strategy.
You beat me to it!

I had been thinking about this a LOT after reading a paper yesterday that a post above led me to....

THANKS to
rmelvey wrote:Rebalancing can boost returns by bringing your portfolio's geometric return closer to the weighted average of the arithmetic returns of its components. I wrote about this concept in a blog post:
http://www.stableinvesting.com/2013/04/ ... demon.html
There is a link in that paper to one published last fall (2012) on "Volatility Harvesting: Why Does Diversifying and Rebalancing Create Portfolio Growth", by Bouchey, Nemtchinov, Paulsen, and Stein (Journal of Wealth Management), where for the first time I got a better idea of the potential for rebalancing.

Before reading this, I kept having a sinking sensation that rebalancing was taking money out of the rapidly growing "pot", and pouring it into the more slowly growing "pot" - e..g., thinking here in broadest terms of "average annual bond returns" and "average annual equity returns" over some long period of time (e.g. past century).

The conclusion seems to be that one would do best to have many/several different categories of investments (sectors, countries, categories [e.g., LC, SV], invest EQUAL AMOUNTS into each, and rebalance frequently, or as frequently as makes sense given trading and other friction costs.
(Vanguard ETF's held at Vanguard, or Schwab ETF's held at Schwab, come to mind in terms of no penalties for short holding periods, no restrictions on purchasing after selling, and no commissions/trading fees.)

The emphasis is on VOLATILITY, and at one point, they seem to suggest that this could work with highly volatile categories even when one of them is in the very long term going down, not up or even holding relatively steady.

I don't know how to insert a link to the paper, because the link I found simply opened up a pdf file directly, rather than another browser window that "showed" the paper.

RM
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Re: Dumb Idea: Rebalancing Boosts Returns

Post by rmelvey »

ResearchMed wrote: THANKS to
rmelvey wrote:Rebalancing can boost returns by bringing your portfolio's geometric return closer to the weighted average of the arithmetic returns of its components. I wrote about this concept in a blog post:
http://www.stableinvesting.com/2013/04/ ... demon.html
There is a link in that paper to one published last fall (2012) on "Volatility Harvesting: Why Does Diversifying and Rebalancing Create Portfolio Growth", by Bouchey, Nemtchinov, Paulsen, and Stein (Journal of Wealth Management), where for the first time I got a better idea of the potential for rebalancing.

Before reading this, I kept having a sinking sensation that rebalancing was taking money out of the rapidly growing "pot", and pouring it into the more slowly growing "pot" - e..g., thinking here in broadest terms of "average annual bond returns" and "average annual equity returns" over some long period of time (e.g. past century).

The conclusion seems to be that one would do best to have many/several different categories of investments (sectors, countries, categories [e.g., LC, SV], invest EQUAL AMOUNTS into each, and rebalance frequently, or as frequently as makes sense given trading and other friction costs.
(Vanguard ETF's held at Vanguard, or Schwab ETF's held at Schwab, come to mind in terms of no penalties for short holding periods, no restrictions on purchasing after selling, and no commissions/trading fees.)

The emphasis is on VOLATILITY, and at one point, they seem to suggest that this could work with highly volatile categories even when one of them is in the very long term going down, not up or even holding relatively steady.

I don't know how to insert a link to the paper, because the link I found simply opened up a pdf file directly, rather than another browser window that "showed" the paper.

RM
Yes the results are quite interesting. I think the validity of volatility harvesting can explain the strong risk adjusted returns of the Permanent Portfolio because it combines 3 high volatility asset classes that over long periods of time have exhibited close to 0 correlation (because of huge fundamental differences in how the asset classes are positioned for different macroeconomic regimes!). I am not sure how much benefit slicing and dicing equity components would have because the correlations are pretty high, but I am open to the idea. I think this article helped me put +1 for Larry's side in the CCF debate.
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Re: Dumb Idea: Rebalancing Boosts Returns

Post by grayfox »

ResearchMed wrote: THANKS to
rmelvey wrote:Rebalancing can boost returns by bringing your portfolio's geometric return closer to the weighted average of the arithmetic returns of its components. I wrote about this concept in a blog post:
http://www.stableinvesting.com/2013/04/ ... demon.html
There is a link in that paper to one published last fall (2012) on "Volatility Harvesting: Why Does Diversifying and Rebalancing Create Portfolio Growth", by Bouchey, Nemtchinov, Paulsen, and Stein (Journal of Wealth Management), where for the first time I got a better idea of the potential for rebalancing.

Before reading this, I kept having a sinking sensation that rebalancing was taking money out of the rapidly growing "pot", and pouring it into the more slowly growing "pot" - e..g., thinking here in broadest terms of "average annual bond returns" and "average annual equity returns" over some long period of time (e.g. past century).

The conclusion seems to be that one would do best to have many/several different categories of investments (sectors, countries, categories [e.g., LC, SV], invest EQUAL AMOUNTS into each, and rebalance frequently, or as frequently as makes sense given trading and other friction costs.
(Vanguard ETF's held at Vanguard, or Schwab ETF's held at Schwab, come to mind in terms of no penalties for short holding periods, no restrictions on purchasing after selling, and no commissions/trading fees.)
That paper on Volatility Harvesting is quite interesting.

Maybe, instead of balancing between TSM and TBM, which long-term is taking from high-return stocks to low-return bonds, we should be balancing between one high-return stock segment and another high-return stock segment.

For instance U.S. stocks are booming now and International are lagging. So we would be selling VTI and buying some VEU.

Also, the fellow's idea of equal weighting 10-sectors and balancing sounds interesting. With Vanguard sector ETFs, a cheap way to get closer to equal-weighted portfolio (EW) which has proven to be better method of indexing that cap-weighting. See paper:

An evaluation of alternative equity indices
Part 1: Heuristic and optimised weighting schemes
Andrew Clare, Nick Motson and Steve Thomas March 2013
Cass Consulting http://www.cassknowledge.com
grayfox
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Re: Dumb Idea: Rebalancing Boosts Returns

Post by grayfox »

WhiskeyJ wrote:
larryswedroe wrote: Third, rebalancing can be expected to add to returns under two conditions; you have assets with similar expected returns and you have RTM. But if you have stocks and bonds which don't have similar expected returns than each time you rebalance from stocks to bonds you are lowering the expected return of the portfolio. Similarly when you sell SV to buy LG the same thing is happening.
I made the decision a few years ago of getting into a sector rebalancing strategy, assuming all sectors had an equal expected return. I equal weighted all 10 vanguard ETF sectors with 50% of an equity allocation (with remaining 50% in total market, total international, and emerging markets). Then I realized I'm essentially overweighting small cap stocks based on VTI sector profile. https://personal.vanguard.com/us/funds/ ... IntExt=INT

I've been gradually exiting this strategy shifting to a simpler portfolio. However, there are no trading costs and virtually no tax implications. So who knows, if there are similar actual returns between the 10 asset classes and low correlation along the way, I suppose this could turn out to be a lucky experiment/experience.
That equal sector-weighting sounds like a promising idea. Why do you want to abandon it? According to the paper above from Cass Consulting, cap-weighted indexing is the worst of all possible indexing-construction methodologies they looked at. It lost to everything else on both return and Sharpe ratio. It even lost to almost all 10 million monkey portfolios. The EW portfolio at least was the monkey average.
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Re: Dumb Idea: Rebalancing Boosts Returns

Post by roymeo »

So I should keep all my new money in my mattress so I don't accidentally rebalance when I add it in?
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