Explain one more time how balance funds work

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Cody
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Explain one more time how balance funds work

Post by Cody » Tue Mar 27, 2018 9:33 am

Suppose you have a balanced fund of some sort with a 60% stock and a 40% bond allocation. And either the stock or bond market drops fairly significantly.

Normally you would sell you better performing holding (I know some argue this is not necessarily best).

But with this balanced fund you are "forced" to sell, at least in part, that worse porforming holding.

How do you reconcile this?

Thanks,
Cody

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Taylor Larimore
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Re: Explain one more time how balance funds work

Post by Taylor Larimore » Tue Mar 27, 2018 9:42 am

Cody wrote:
Tue Mar 27, 2018 9:33 am
Suppose you have a balanced fund of some sort with a 60% stock and a 40% bond allocation. And either the stock or bond market drops fairly significantly.

Normally you would sell you better performing holding (I know some argue this is not necessarily best).

But with this balanced fund you are "forced" to sell, at least in part, that worse porforming holding.

How do you reconcile this?

Thanks,
Cody
Cody:

One of the advantages of a balanced fund (stocks and bonds in one fund) is that you do not do anything. The fund keeps the same allocations by rebalancing for you.

Best wishes.
Taylor
"Simplicity is the master key to financial success." -- Jack Bogle

alex_686
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Re: Explain one more time how balance funds work

Post by alex_686 » Tue Mar 27, 2018 9:52 am

Cody wrote:
Tue Mar 27, 2018 9:33 am
But with this balanced fund you are "forced" to sell, at least in part, that worse porforming holding.
Past performance does not have predictive power over future performance. So if yesterday you thought that 60/40 was the optimal AA, what information, theory, or logic has changed to alter that belief?

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Re: Explain one more time how balance funds work

Post by Cody » Tue Mar 27, 2018 10:00 am

I may not be making myself clear.

Say bonds hold at 0% return and equity drops by 25%.

Normally at RMD you would probably sell bonds.

With balanced funds you have not choice which to sell (which may be part of the beauty of a BF but not as efficient).

Is it a big deal?

Cody

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Re: Explain one more time how balance funds work

Post by goblue100 » Tue Mar 27, 2018 10:27 am

Cody wrote:
Tue Mar 27, 2018 10:00 am
I may not be making myself clear.

Say bonds hold at 0% return and equity drops by 25%.

Normally at RMD you would probably sell bonds.

With balanced funds you have not choice which to sell (which may be part of the beauty of a BF but not as efficient).

Is it a big deal?

Cody
I say no big deal. The balanced fund has to maintain it's balance, so in your example above what do you think they will redeem to meet withdrawal requests? Bonds, of course.
Some people are immune to good advice. - Saul Goodman

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Re: Explain one more time how balance funds work

Post by lack_ey » Tue Mar 27, 2018 10:46 am

Cody wrote:
Tue Mar 27, 2018 10:00 am
I may not be making myself clear.

Say bonds hold at 0% return and equity drops by 25%.

Normally at RMD you would probably sell bonds.

With balanced funds you have not choice which to sell (which may be part of the beauty of a BF but not as efficient).

Is it a big deal?

Cody
The balanced fund already sold bonds ahead of you. Unless you're specifically wanting to run something other than the balanced fund's splits under certain market conditions, I don't see what the issue is. You're not arguing that it's rebalancing too quickly, are you?


Example:
$1 million starting allocation, 60/40 balanced fund, 25% instant drop in stocks -> balanced fund has brought allocation back to 60/40 and now owns $510k stocks, $340k bonds (it sold 15% of its bonds to make this happen). You take $40k of what remains, leaving $810k ($486k stocks, $324k bonds).

or

$1 million starting allocation 60% stocks, 40% bonds held directly, 25% instant drop in stocks -> $450k stocks and $400k bonds remaining, you take $40k of what remains from the bonds, leaving $810k ($450k stocks, $360k bonds). The asset allocation is still off at 55.6%/44.4% so now you probably want to sell even more bonds to get to $486k stocks, $324k bonds and 60%/40% again.

Now, if a market drop is not instantaneous, the balanced fund should be buying more of the underperforming asset on the way down (selling what's doing relatively better). This can make drops a little worse than if the rebalancing were less frequent.

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Re: Explain one more time how balance funds work

Post by ogd » Tue Mar 27, 2018 10:53 am

Cody wrote:
Tue Mar 27, 2018 9:33 am
But with this balanced fund you are "forced" to sell, at least in part, that worse porforming holding.

How do you reconcile this?
It's not a big deal. The fund has been buying stocks after they started dropping and selling bonds, so compared to the beginning of that period you have indeed sold more bonds than proportional.

More importantly, the balance is still 60/40 after you sell, which is what you want. If you now think you want 65/35 because "stocks are cheap" (this smacks of market timing, btw), you can simply sell a bit more and buy a pure stock fund to get that balance. With liquid stocks, this should cost you very little in terms of friction costs.

It's just taxes that are an issue. It's inefficient to sell what the fund just bought (stocks), and possibly to do the allocation adjustment transaction as well if you have capital gains. That's one of the main reasons we don't recommend these funds in taxable accounts. In tax-advantaged accounts, though, they work just fine.

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Re: Explain one more time how balance funds work

Post by Cody » Tue Mar 27, 2018 2:23 pm

I am beginning to make sense of this (I think).

I have almost no taxable funds (sold them some time back to pay for a Social Security delay until I'm 70 (next year). Also used some of it to pay taxes on large Roth conversions over the last several years.

My general conclusion is that balanced funds sure reduces the number of steps needed to manage a portfolio.

Anything else to add?
Cody

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Re: Explain one more time how balance funds work

Post by FactualFran » Tue Mar 27, 2018 2:53 pm

Cody wrote:
Tue Mar 27, 2018 2:23 pm
My general conclusion is that balanced funds sure reduces the number of steps needed to manage a portfolio.

Anything else to add?
Another way to put it is that the manager of a balanced fund takes care of the details of rebalancing, including when it is done.

The statement in the opening post about being "'forced' to sell, at least in part, that worse porforming holding" indicates a preference to avoid having someone else determine when rebalancing is done. The preference is to let a stock/bond ratio stray more from a target allocation than a balanced fund would and to rebalance when making anticipated redemptions.

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Re: Explain one more time how balance funds work

Post by alex_686 » Tue Mar 27, 2018 3:30 pm

Cody wrote:
Tue Mar 27, 2018 10:00 am
Normally at RMD you would probably sell bonds.
Why does this matter? I suspect that it is some version informal heuristic method of asset allocation, risk strategy, or withdraw strategy. Maybe loss aversion.

Having a 60/40 portfolio is based of formal investment theory, mostly in creating a mean variant portfolio - highest return for a given level of risk. It is also partially based of the efficient market hypothesis. The market has incorporated new information which is why one asset has fallen. You are not smarter than the market. Readjust your portfolio accordingly.

So, yes, it does reduce the number of steps you take. However it does rest on solid theory.

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Re: Explain one more time how balance funds work

Post by nisiprius » Tue Mar 27, 2018 3:52 pm

Here's why I think it's not a big deal. You simply have to contrive an unusual situation to see any big difference in the results of rebalancing strategy. For example, the blue line here is the Vanguard Balanced Index Fund, which rebalances almost continuously to a 60/40 allocation, and the red line is a holding that starts at 60% Total Stock, 40% Total Bond and follows a "rebalancing bands" strategy. In both cases we begin at the inception of Balanced Index:

Source
Image

Now we can conduct a long debate on how much the difference is, whether it's likely to persist, etc. but I insist it just didn't matter much.

But certainly, if you don't trust balanced funds, don't use them.
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Re: Explain one more time how balance funds work

Post by nisiprius » Tue Mar 27, 2018 4:03 pm

alex_686 wrote:
Tue Mar 27, 2018 3:30 pm
Having a 60/40 portfolio is based of formal investment theory, mostly in creating a mean variant portfolio - highest return for a given level of risk...
I have tried and failed to find any good explanation of how the traditional 60/40 portfolio was derived. If you have a reference that demonstrates 60/40 as an optimum, I'd like to know it.

There's actually "wisdom" for 50/50. Benjamin Graham said "the standard division should be an equal one, or 50–50." John C. Bogle in "Twelve Pillars" wrote that "There are an infinite number of strategies worse than this one: Commit, over a period of a few years, half of your assets to a stock index fund and half to a bond index fund..." Harry Markowitz, describing his own choice, wrote "My intention was to minimize my future regret, so I split my [pension scheme] contributions 50/50 between bonds and equities."

I've also played around extensively with the SBBI data for "large-company stocks" and either "intermediate-term government bonds" or "long-term government bonds," trying to find a plausible time period over which 60/40 was the optimum... and I couldn't do it. For most "reasonable" periods of time the optimum stock allocation was far below 60%. For 1926 through 2016, using intermediate-term government bonds, it was 27/73. I can only only get 60/40 by working quite hard at cherry-picking and deliberately selecting short periods of time dominated by bull markets in stocks. Over what range of years do you think 60/40 was the mean-variance optimum?
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Re: Explain one more time how balance funds work

Post by alex_686 » Wed Mar 28, 2018 11:28 am

nisiprius wrote:
Tue Mar 27, 2018 4:03 pm
I've also played around extensively with the SBBI data for "large-company stocks" and either "intermediate-term government bonds" or "long-term government bonds," trying to find a plausible time period over which 60/40 was the optimum... and I couldn't do it. ... Over what range of years do you think 60/40 was the mean-variance optimum?
By definition you can't do it this way. In fact, if you had found a range where it worked that would be a yellow flag that you were doing something wrong.

I think you are confusing a priori and a posteriori. A mean variance portfolio is constructed using a posteriori information - predictions on how the future will work. Historical testing is construed using a posteriori information - how things worked in the past. If one assumes that things will work in the future as they did in the past than past information is helpful. However we are not dealing with science or engineering, where we have stable systems and this is a valid assumption. We are dealing with dynamic systems, where the future probably will not resemble the past.

Now to back away from my original statement. In the simplest form, to create a a mean-variance portfolio one needs to estimate returns, standard deviations for risk, and the covariance. This is hard. As mentioned above there is not a historical stable relations. Small differences in the inputs can create radically different portfolios.

In short, not a exact science. 60/40 is thrown around as conventional wisdom. If you want to argue that 50/50 is better, I would be happy to engage in that debate. My current thinking is that 70/30 is better, with a small position towards REITs. I think that is one of the reasons why Bogleheads exists - to discusses the fine points.

However, back to the OP question. I think Nisiprius and I are discussing the fine points on where the correct balance is. I don't think we are actually debating the validity of using a mean-variance portfolio as a formal expression of theory to create a AA. One of the virtues of the mean-variant portfolio and the 60/40 split is that it is simple and has a robust history. I think there are better options out there, but they tend to be complex.

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Re: Explain one more time how balance funds work

Post by FactualFran » Wed Mar 28, 2018 1:51 pm

There are circumstances when taking RMDs from a balanced fund would have resulted in lower portfolio balances versus using an initially equivalent portfolio of separate stock and bond funds, without necessarily rebalancing to the target stock:bond allocation of the balanced fund.

An example is using the Vanguard Balanced Index fund starting at the end of 1999 with the first RMD taken at the end of 2000, and the later RMDs taken at the end of each following year. The Vanguard Balanced Index fund has a target allocation of 60% total stock market index and 40% total bond market index. The total stock market index had large negative returns each year from 2000 to 2002.

The balanced fund would have rebalanced back to the target allocation, moving money from bonds to stocks, stocks that had large negative returns compared to bonds during some immediately following years. With the separate stock and bond funds, the RMDs would have been taken from the bond fund, and no money would have been moved to the stock fund. The portfolio of separate stock and bond funds would have had a higher balance due to a lower percentage of the portfolio being in stocks that had much lower returns than bonds from 2000 to 2002.

With the portfolio of separate stock and bond funds, the RMDs would have been taken only from the bond fund in 2000 through 2003. In 2004 the stock balance would have recovered enough for 2% of the RMD to be taken from it. Starting with 2012, the RMDs would have been taken only from the stock fund.

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Re: Explain one more time how balance funds work

Post by arcticpineapplecorp. » Wed Mar 28, 2018 8:54 pm

nisiprius wrote:
Tue Mar 27, 2018 4:03 pm
alex_686 wrote:
Tue Mar 27, 2018 3:30 pm
Having a 60/40 portfolio is based of formal investment theory, mostly in creating a mean variant portfolio - highest return for a given level of risk...
I have tried and failed to find any good explanation of how the traditional 60/40 portfolio was derived. If you have a reference that demonstrates 60/40 as an optimum, I'd like to know it.

There's actually "wisdom" for 50/50. Benjamin Graham said "the standard division should be an equal one, or 50–50." John C. Bogle in "Twelve Pillars" wrote that "There are an infinite number of strategies worse than this one: Commit, over a period of a few years, half of your assets to a stock index fund and half to a bond index fund..." Harry Markowitz, describing his own choice, wrote "My intention was to minimize my future regret, so I split my [pension scheme] contributions 50/50 between bonds and equities."

I've also played around extensively with the SBBI data for "large-company stocks" and either "intermediate-term government bonds" or "long-term government bonds," trying to find a plausible time period over which 60/40 was the optimum... and I couldn't do it. For most "reasonable" periods of time the optimum stock allocation was far below 60%. For 1926 through 2016, using intermediate-term government bonds, it was 27/73. I can only only get 60/40 by working quite hard at cherry-picking and deliberately selecting short periods of time dominated by bull markets in stocks. Over what range of years do you think 60/40 was the mean-variance optimum?
I'm not sure where I read it (if someone remembers please let me know...I'm sure we've all read the same books :happy ) but it was something to the effect of:

If you want a balanced portfolio go with 50/50.
If you want a balanced portfolio but are concerned about inflation go with 60/40
If you want a balanced portfolio but are concerned with volatility go with 40/60

That makes sense. They're all balanced portfolios with a slight tilt to eith stocks, bonds or evenly split between the two.
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Re: Explain one more time how balance funds work

Post by montanagirl » Wed Mar 28, 2018 9:08 pm

alex_686 wrote:
Wed Mar 28, 2018 11:28 am
nisiprius wrote:
Tue Mar 27, 2018 4:03 pm
I've also played around extensively with the SBBI data for "large-company stocks" and either "intermediate-term government bonds" or "long-term government bonds," trying to find a plausible time period over which 60/40 was the optimum... and I couldn't do it. ... Over what range of years do you think 60/40 was the mean-variance optimum?
By definition you can't do it this way. In fact, if you had found a range where it worked that would be a yellow flag that you were doing something wrong.

I think you are confusing a priori and a posteriori. A mean variance portfolio is constructed using a posteriori information - predictions on how the future will work. Historical testing is construed using a posteriori information - how things worked in the past. If one assumes that things will work in the future as they did in the past than past information is helpful. However we are not dealing with science or engineering, where we have stable systems and this is a valid assumption. We are dealing with dynamic systems, where the future probably will not resemble the past.

Now to back away from my original statement. In the simplest form, to create a a mean-variance portfolio one needs to estimate returns, standard deviations for risk, and the covariance. This is hard. As mentioned above there is not a historical stable relations. Small differences in the inputs can create radically different portfolios.

In short, not a exact science. 60/40 is thrown around as conventional wisdom. If you want to argue that 50/50 is better, I would be happy to engage in that debate.

I have been wondering why VG doesn't offer a 50/50 fund.

Or do they?

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Re: Explain one more time how balance funds work

Post by MotoTrojan » Wed Mar 28, 2018 9:46 pm

montanagirl wrote:
Wed Mar 28, 2018 9:08 pm
alex_686 wrote:
Wed Mar 28, 2018 11:28 am
nisiprius wrote:
Tue Mar 27, 2018 4:03 pm
I've also played around extensively with the SBBI data for "large-company stocks" and either "intermediate-term government bonds" or "long-term government bonds," trying to find a plausible time period over which 60/40 was the optimum... and I couldn't do it. ... Over what range of years do you think 60/40 was the mean-variance optimum?
By definition you can't do it this way. In fact, if you had found a range where it worked that would be a yellow flag that you were doing something wrong.

I think you are confusing a priori and a posteriori. A mean variance portfolio is constructed using a posteriori information - predictions on how the future will work. Historical testing is construed using a posteriori information - how things worked in the past. If one assumes that things will work in the future as they did in the past than past information is helpful. However we are not dealing with science or engineering, where we have stable systems and this is a valid assumption. We are dealing with dynamic systems, where the future probably will not resemble the past.

Now to back away from my original statement. In the simplest form, to create a a mean-variance portfolio one needs to estimate returns, standard deviations for risk, and the covariance. This is hard. As mentioned above there is not a historical stable relations. Small differences in the inputs can create radically different portfolios.

In short, not a exact science. 60/40 is thrown around as conventional wisdom. If you want to argue that 50/50 is better, I would be happy to engage in that debate.

I have been wondering why VG doesn't offer a 50/50 fund.

Or do they?
I believe tax-managed balanced is, but it doesn’t have any international.

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"The optimum stock/bond portfolio?"

Post by Taylor Larimore » Wed Mar 28, 2018 9:48 pm

Bogleheads:

Knowledgeable investors do not use an "optimum stock/bond portfolio" (whatever that is). They structure their stock/bond allocation based on their goals, their time-frame, their risk-tolerance and their personal financial situation.

Best wishes.
Taylor
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Re: Explain one more time how balance funds work

Post by BogleMelon » Wed Mar 28, 2018 9:55 pm

Cody wrote:
Tue Mar 27, 2018 9:33 am

But with this balanced fund you are "forced" to sell, at least in part, that worse porforming holding.

How do you reconcile this?
No, the balanced fund are forced to buy the worse performing by selling the best performing. Same as you would do exactly, yet more efficiently.
"One of the funny things about stock market, every time one is buying another is selling, and both think they are astute" - William Feather

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Re: Explain one more time how balance funds work

Post by BogleMelon » Wed Mar 28, 2018 9:58 pm

Cody wrote:
Tue Mar 27, 2018 10:00 am
I may not be making myself clear.

Say bonds hold at 0% return and equity drops by 25%.

Normally at RMD you would probably sell bonds.
And so will the balanced fund, it will sell bonds to buy stocks, to stay balanced (at least theoretically, because there are other factors such as new money that could reduce the need to actually sell the exact 25% of bonds)
"One of the funny things about stock market, every time one is buying another is selling, and both think they are astute" - William Feather

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Re: Explain one more time how balance funds work

Post by ogd » Thu Mar 29, 2018 12:33 am

FactualFran wrote:
Wed Mar 28, 2018 1:51 pm
There are circumstances when taking RMDs from a balanced fund would have resulted in lower portfolio balances versus using an initially equivalent portfolio of separate stock and bond funds, without necessarily rebalancing to the target stock:bond allocation of the balanced fund.
Yes, but this is entirely due to having rebalanced rather than to the fund specifically. Or even RMDs specifically.

The non-rebalancing owner was the winner in this case. Over a period when stocks declined, they had a safer allocation than their normal 60/40, before the RMDs or even after.

Did they have an a priori reason for being below allocation? I can think of some, like trend following, or being scared of the economy, or wanting constant safety from the bonds, or even preparing for the RMD by treating part of the allocation as very short term. Some of these sound like market timing more than others. But I don't think it's any of these actually, I think it's just you testing the position of inaction among other allocation strategies and finding a case where it worked better. In other circumstances, rebalancing on various schedules worked better by e.g. buying stocks right at the bottom and getting a nice 10% boost before the RMD.

In any case, the fund isn't to blame for this, rebalancing is. The fund doesn't even exclude any of the above strategies, e.g. it's easy enough to bump up the bond allocation some time before the RMD on the side. The fund merely gives someone who has decided on a 60/40 allocation in all market conditions exactly what they want. Personally, I don't think I know enough to read anything at all about market conditions, and even something like "my risk parameters have changed in this economy" is a deep rabbit hole. With no effort required to rebalance (the balanced fund) there's no reason not to rebalance all the time.

That is, when taxes aren't an issue.

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Re: Explain one more time how balance funds work

Post by Beehave » Thu Mar 29, 2018 4:10 am

ogd wrote:
Thu Mar 29, 2018 12:33 am
FactualFran wrote:
Wed Mar 28, 2018 1:51 pm
There are circumstances when taking RMDs from a balanced fund would have resulted in lower portfolio balances versus using an initially equivalent portfolio of separate stock and bond funds, without necessarily rebalancing to the target stock:bond allocation of the balanced fund.
Yes, but this is entirely due to having rebalanced rather than to the fund specifically. Or even RMDs specifically.

The non-rebalancing owner was the winner in this case. Over a period when stocks declined, they had a safer allocation than their normal 60/40, before the RMDs or even after.

Did they have an a priori reason for being below allocation? I can think of some, like trend following, or being scared of the economy, or wanting constant safety from the bonds, or even preparing for the RMD by treating part of the allocation as very short term. Some of these sound like market timing more than others. But I don't think it's any of these actually, I think it's just you testing the position of inaction among other allocation strategies and finding a case where it worked better. In other circumstances, rebalancing on various schedules worked better by e.g. buying stocks right at the bottom and getting a nice 10% boost before the RMD.

In any case, the fund isn't to blame for this, rebalancing is. The fund doesn't even exclude any of the above strategies, e.g. it's easy enough to bump up the bond allocation some time before the RMD on the side. The fund merely gives someone who has decided on a 60/40 allocation in all market conditions exactly what they want. Personally, I don't think I know enough to read anything at all about market conditions, and even something like "my risk parameters have changed in this economy" is a deep rabbit hole. With no effort required to rebalance (the balanced fund) there's no reason not to rebalance all the time.

That is, when taxes aren't an issue.
Question based on the above - - - In terms of performance of two possible 60/40 portfolios in an IRA:

Portfolio A = 60% Total US stock fund, 40% Total US Bond rebalanced once a year
Portfolio B = 60/40 Total US Stock and Bond fund rebalanced daily (or however frequently the Vanguard 60/40 Balanced fund rebalances)

Would it be true that if one of the assets (say stocks) steadily outperformed the other over the course of the year that Portfolio A would outperform Portfolio B, whereas if instead there were high volatility in one asset (say in stocks) but not the other, then Portfolio B would outperform Portfolio A?

And a follow-on question - - - If there is a difference between Portfolio A and B's performance based on relative volatility, would having more diversely variable assets in the fund increase the delta between A and B? Specifically, would adding a 60/40 component of international stocks and bonds to Portfolio A and to Portfolio B tend to further increase or decrease the difference in performance (or is it not possible to determine)?

Thanks!

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Re: Explain one more time how balance funds work

Post by nisiprius » Thu Mar 29, 2018 8:21 am

alex_686 wrote:
Wed Mar 28, 2018 11:28 am
...My current thinking is that 70/30 is better, with a small position towards REITs...
I've told you how I calculated the numbers 27/73. How did you (or anyone else) calculate the numbers 70/30? Or 60/40?
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Re: Explain one more time how balance funds work

Post by Cody » Thu Mar 29, 2018 9:16 am

OP here.

I'm not sure if those who currently have a balanced fund of some sort have concluded anything about "rebalancing" their own portfolio vs letting the the fund itself do it.

But is it safe to assume that on "average balance" funds at Vanguard (Target, Lifestyle, etc) generally do as well as individual portfolios that get rebalanced?

Cody

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Re: Explain one more time how balance funds work

Post by alex_686 » Thu Mar 29, 2018 9:34 am

Cody wrote:
Thu Mar 29, 2018 9:16 am
I'm not sure if those who currently have a balanced fund of some sort have concluded anything about "rebalancing" their own portfolio vs letting the the fund itself do it.

But is it safe to assume that on "average balance" funds at Vanguard (Target, Lifestyle, etc) generally do as well as individual portfolios that get rebalanced?
On the plus side, Fund of Funds (FoF) are highly discipline and are very simple to use. However they are generic and have a slightly higher costs. It is not obvious which is better - FoF or do it yourself - it depends on the individual.

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Re: Explain one more time how balance funds work

Post by Taylor Larimore » Thu Mar 29, 2018 9:35 am

But is it safe to assume that on "average balance" funds at Vanguard (Target, Lifestyle, etc) generally do as well as individual portfolios that get rebalanced?
Cody:

My guess is that the "average balance funds at Vanguard" do better than individual portfolios that get rebalanced. Three primary reasons:

1. Balanced funds are designed by Vanguard experts.

2. Balanced funds rebalance themselves.

3. Balanced funds discourage "tinkering."

Caveat: Balanced funds are tax-inefficient and seldom suitable inside taxable accounts.

Best wishes.
Taylor
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Re: Explain one more time how balance funds work

Post by rixer » Thu Mar 29, 2018 9:39 am

Cody wrote:
Thu Mar 29, 2018 9:16 am
OP here.

I'm not sure if those who currently have a balanced fund of some sort have concluded anything about "rebalancing" their own portfolio vs letting the the fund itself do it.

But is it safe to assume that on "average balance" funds at Vanguard (Target, Lifestyle, etc) generally do as well as individual portfolios that get rebalanced?

Cody
Cody, for me, a balanced fund does better because it does keep in balance at all times. I let things drift too conservatively if nervous about the economy . With the balanced fund, I accept what the market will give me and I don't have to actually sell one or the other, it stays in balance automatically. Thus I've made more because I don't have to decide when to pull the trigger. I've left a lot of money on the table before I switched to a LS fund.

In fact, I only really look at the ticker price of the balanced fund itself and rarely look at the 4 individual index funds it's made up with so there's even less stress when things drop.

That is how a balanced fund has helped me. I doubt there's much difference if you are dedicated enough to follow through. Some people are and others aren't. I know my limitations. :beer

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Re: Explain one more time how balance funds work

Post by nisiprius » Thu Mar 29, 2018 9:55 am

Cody wrote:
Thu Mar 29, 2018 9:16 am
OP here.

I'm not sure if those who currently have a balanced fund of some sort have concluded anything about "rebalancing" their own portfolio vs letting the the fund itself do it.

But is it safe to assume that on "average balance" funds at Vanguard (Target, Lifestyle, etc) generally do as well as individual portfolios that get rebalanced?

Cody
The cleanest comparison I can make is to compare the Vanguard Balanced Index Fund to a rebalanced portfolio of Total Stock and Total Bond. (The problem with trying to use other balanced funds for comparison that they have not been perfectly stable in composition over time).

At one time Balanced Index was literally a fund-of-funds, but has now been revamped. It is, nevertheless supposed to be equivalent to a 60/40 allocation to Total Stock and Total Bond--rebalanced in whatever way Vanguard does it. So, Balanced Index is "rebalanced by Vanguard." Using PortfolioVisualizer, we can compare it to and actual portfolio of 60% Total Stock, 40% Total Bond, "rebalanced by investor" in various ways. I am using Investor shares: VBINX, VTSMX, VBMFX because that lets me look at a longer period of time.

In each case, Portfolio 1, blue, is VBINX--"Vanguard rebalancing within a balanced fund."
Portfolio 2, red, is "Investor rebalancing of separate Total Stock and Total Bond."
Rebalancing regimes are those provided by PortfolioVisualizer.
Oct 1992 - Feb 2018

Source

"Rebalance monthly"
Image

"Rebalance annually"
Image

"Rebalance bands (5%/25%)"
Image

Make of all that what you will.
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Re: Explain one more time how balance funds work

Post by pkcrafter » Thu Mar 29, 2018 11:49 am

cody, does the issue with balanced funds you are trying to explain pertain to withdrawals when stocks are down, and with a balanced fund you must also withdraw from equity whereas with individual funds you would not withdraw equity?

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Re: Explain one more time how balance funds work

Post by FactualFran » Thu Mar 29, 2018 2:29 pm

ogd wrote:
Thu Mar 29, 2018 12:33 am
FactualFran wrote:
Wed Mar 28, 2018 1:51 pm
There are circumstances when taking RMDs from a balanced fund would have resulted in lower portfolio balances versus using an initially equivalent portfolio of separate stock and bond funds, without necessarily rebalancing to the target stock:bond allocation of the balanced fund.
Yes, but this is entirely due to having rebalanced rather than to the fund specifically. Or even RMDs specifically.
My post was specifically about taking RMDs, as was the opening post. When starting at the end of 1999 and taking RMDs for 2000 onward at the end of the year from a portfolio of separate total stock market and total bond market funds, the portfolio allocation at the end of each year was not always 60:40.

The minimum percentage in stocks was 48% at the end of 2002. Because the portfolio of separate funds had a lower percentage in stocks at the end of 2002 than the balanced fund, the portfolio of separate funds did not benefit as much as the balanced fund from the high return of the stock fund in 2003.

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Re: Explain one more time how balance funds work

Post by Cody » Fri Mar 30, 2018 10:06 am

cody, does the issue with balanced funds you are trying to explain pertain to withdrawals when stocks are down, and with a balanced fund you must also withdraw from equity whereas with individual funds you would not withdraw equity?

Paul
That is correct Paul. In a down equitiy market (with a BF) you are "forced" to sell in a down stock market. With a Non BF you have a choice what to sell. In this case you would sell from the fixed side.

I am just trying to figure out if that move (sellling stocks in a down stock market) is some how "compensated" for in the BF. Are the mechanics of the BF somehow making this problem mitigated some how?

Cody

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Re: Explain one more time how balance funds work

Post by UpperNwGuy » Fri Mar 30, 2018 10:17 am

Cody wrote:
Fri Mar 30, 2018 10:06 am
cody, does the issue with balanced funds you are trying to explain pertain to withdrawals when stocks are down, and with a balanced fund you must also withdraw from equity whereas with individual funds you would not withdraw equity?

Paul
That is correct Paul. In a down equitiy market (with a BF) you are "forced" to sell in a down stock market. With a Non BF you have a choice what to sell. In this case you would sell from the fixed side.

I am just trying to figure out if that move (sellling stocks in a down stock market) is some how "compensated" for in the BF. Are the mechanics of the BF somehow making this problem mitigated some how?

Cody
Cody, I am confused by your statement. If the equity market is down, you would sell bonds and buy stocks if you had them as separate funds. In a balanced fund, the fund manager would do the very same thing (sell bonds and buy stocks) without your having to take any action. What am I missing?

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Re: Explain one more time how balance funds work

Post by Cody » Sat Mar 31, 2018 10:33 am

My explaining is subpar for sure - which leads to confusion by the reader. It shows I too am confused.

Let say you have two portfolios - 1. A Balanced Fund (BF) of 60-40 and 2. A 3 Fund Portfolio (3FP) of 60-40 which is currently at exactly 60-40 (no rebalncing needed)

RMD comes along and you must take $1000. With the BF you sell $1000 worth of shares. But with the 3FP you sell $60 worth of eqyity and $40 bonds.
Easy enough.

But now lets say the stock market has drop considerably. And RMD comes along.
Repeat the above for the BF (but in doing so you have sold equity and bonds). But on the 3FP side you would probable sell just bonds for the RMD to get back to 60-40 (thus rebalancing).

Does this mean that with the BF you are selling stocks at a bad time (remember with the 3FP you sold only bonds).

Help straighten me out. Am I missing a step that compensates to the sale of equity in the BF at a bad time?

Cody

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Re: Explain one more time how balance funds work

Post by DSInvestor » Sat Mar 31, 2018 10:40 am

Cody wrote:
Sat Mar 31, 2018 10:33 am
My explaining is subpar for sure - which leads to confusion by the reader. It shows I too am confused.

Let say you have two portfolios - 1. A Balanced Fund (BF) of 60-40 and 2. A 3 Fund Portfolio (3FP) of 60-40 which is currently at exactly 60-40 (no rebalncing needed)

RMD comes along and you must take $1000. With the BF you sell $1000 worth of shares. But with the 3FP you sell $60 worth of eqyity and $40 bonds.
Easy enough.

But now lets say the stock market has drop considerably. And RMD comes along.
Repeat the above for the BF (but in doing so you have sold equity and bonds). But on the 3FP side you would probable sell just bonds for the RMD to get back to 60-40 (thus rebalancing).

Does this mean that with the BF you are selling stocks at a bad time (remember with the 3FP you sold only bonds).

Help straighten me out. Am I missing a step that compensates to the sale of equity in the BF at a bad time?

Cody
When you sell shares of a balanced fund, the fund manager will determine which asset classes to sell to maintain the fund's AA. The manager facing net redemptions while equities are falling would sell bonds from the fund to maintain the 60/40 allocation just like the investor holding 3 fund portfolio. In fact, the fund manager may decide to sell bonds to buy stocks if equities are falling hard to maintain the asset allocation. Just after 2008/2009 financial crisis, Vanguard changed the underlying funds in the Target Retirement and LifeStrategy funds because the rebalancing actions in that period was driving up expenses for regular investors in the Total Bond Market Index fund. Vanguard created a separate fund called Total Bond Market Index II to be held by Vanguard's funds of funds in order to isolate the regular TBM fund from rebalancing action.

viewtopic.php?t=31586
Vanguard wrote:"Vanguard has introduced a new broad-market bond index fund for use by Vanguard funds, including Vanguard's Target Retirement and LifeStrategy® funds, that invest in other Vanguard offerings.

Vanguard Total Bond Market II Index Fund seeks to track the performance of the Barclays Capital U.S. Aggregate Bond Index (formerly the Lehman Brothers U.S. Aggregate Bond Index). The new fund shares the same portfolio management strategy and investment policies as the $65 billion Vanguard Total Bond Market Index Fund, which was introduced in 1986 as the mutual fund industry's first index bond fund.

Vanguard Total Bond Market II Index Fund will only be available for use by Vanguard funds-of-funds and other similar investment products; shares of the new fund will not be available for direct purchase by investors.

Vanguard Total Bond Market Index Fund is the primary bond component of Vanguard's 11 Target Retirement and four LifeStrategy funds, which regularly rebalance assets among the underlying funds to maintain their respective target asset allocations. Vanguard is introducing the new fund to insulate shareholders of the existing bond market index fund from the potential costs associated with this rebalancing activity."
[Emphasis added.]
Given that you mentioned RMD, associated with tax advantaged accounts, you have NO capital gain issue. Investors holding funds in taxable accounts have to deal with realized capital gains. A bond fund derives most of its return from income and is unlikely to have large unrealized capital gains. A balanced fund holding 60% stocks is likely to get most of its return for capital return, which means a greater change of realizing capital gains when selling shares. For tax efficiency reasons, we often recommend against holding balanced/TR/LS funds in taxable accounts here at bogleheads unless the investor is in a low tax bracket.
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Re: Explain one more time how balance funds work

Post by ogd » Sat Mar 31, 2018 1:25 pm

Cody wrote:
Sat Mar 31, 2018 10:33 am
My explaining is subpar for sure - which leads to confusion by the reader. It shows I too am confused.

Let say you have two portfolios - 1. A Balanced Fund (BF) of 60-40 and 2. A 3 Fund Portfolio (3FP) of 60-40 which is currently at exactly 60-40 (no rebalncing needed)

RMD comes along and you must take $1000. With the BF you sell $1000 worth of shares. But with the 3FP you sell $600 worth of eqyity and $400 bonds.
Easy enough.

But now lets say the stock market has drop considerably. And RMD comes along.
Repeat the above for the BF (but in doing so you have sold equity and bonds). But on the 3FP side you would probable sell just bonds for the RMD to get back to 60-40 (thus rebalancing).

Does this mean that with the BF you are selling stocks at a bad time (remember with the 3FP you sold only bonds).

Help straighten me out. Am I missing a step that compensates to the sale of equity in the BF at a bad time?
Yes, the step that you're missing is that the fund already sold bonds to buy more stocks before your transaction. So overall, you sold more bonds than in the sale you executed by hand, due to automatic rebalancing.

With your numbers, having added a missing zero to the amounts in bold:

Suppose the portfolio was $10k. Suppose stocks dropped 33%, leaving the unbalanced 3FP at $4k / $4k -- a 50/50 allocation. Suppose this happened all in one day, a Black Monday, for simplicity.

Immediately after the Black Monday, the balanced fund worked to restore the 60/40 balance. It sold $800 of bonds and bought $800 of stocks, leaving your share of the fund with $4.8k stocks, $3.2k bonds. When you then sell $1000, it takes it 60/40 from this, leaving your share at $4.2k stocks / 2.8k bonds -- still a 60/40 allocation.

Now if you look at net buy/share from both of those transactions, stocks are +$800 - $600 = +$200, bonds are -$800 - $400 = $-1200. So all your sales occured from the bond portion and you are still a net buyer of stocks.

The ending balances are exactly the same with the 3FP if after a $1000 bond sale you also restore the 60/40 balance as you probably should if that's your desired allocation. So having sold the RMD $1k bonds which brought it to $4k/3k, the balance is now 57/43, and to restore it to 60/40 you sell a further $200 bonds ending up with $4.2k / $2.8k just like the BF share.

In general, whether the stock drop was smaller or larger than my example, if you assume the manual 3FP will rebalance after the sale, it will always end up with the same balance, so the BF doesn't hurt. If the 3FP doesn't rebalance, then you must come up with a good reason why a 60/40 allocation is no longer the desired one.

In general, what matters is not whether you sell stocks at a loss or not (we in fact do this all the time in taxable accounts for Tax Loss Harvesting), but what the net change is and the allocation going forward.

Now where the two legitimately differ is the less-simplified case when the 33% drop occured over a period of time. Here the BF continuously bought stocks, exposing them to further drops in value in this case. But there are other cases when that was a big advantage -- when stocks quickly recovered and the freshly bought stocks were a nice profit by the time of the RMD. You can't blame the fund for maintaining your allocation through a bad market -- once again, if you say a smaller allocation is appropriate during stock drops, and not just a lucky result of inaction, you have to come up with a reason for that, which will end up looking like market timing to most of us.

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Re: Explain one more time how balance funds work

Post by ogd » Sat Mar 31, 2018 2:20 pm

Beehave wrote:
Thu Mar 29, 2018 4:10 am
Portfolio A = 60% Total US stock fund, 40% Total US Bond rebalanced once a year
Portfolio B = 60/40 Total US Stock and Bond fund rebalanced daily (or however frequently the Vanguard 60/40 Balanced fund rebalances)

Would it be true that if one of the assets (say stocks) steadily outperformed the other over the course of the year that Portfolio A would outperform Portfolio B,
Yes. Portfolio A achieved this by having more stocks on average, i.e. taking more risk for more reward (in this case). It's the usual tradeoff and not a problem with rebalancing. Like in my email above, if you say that a larger stock allocation is appropriate after stocks have gone up, you have to justify it and it rather looks like market timing.
Beehave wrote:
Thu Mar 29, 2018 4:10 am
whereas if instead there were high volatility in one asset (say in stocks) but not the other, then Portfolio B would outperform Portfolio A?
This is hard to say without knowing the timing and the returns. If stocks ended up returning the same or less than bonds over the high-volatility period I think it's likely (perhaps even guaranteed, haven't thought the math through) that the rebalanced portfolio did better. This wasn't magic either -- it simply bought an asset that is known to rebound in our scenario, or sold it before it's known to drop back down. In real life we don't have the luxury of knowing this in advance, so the real reason to rebalance is to stay on track with our chosen allocation.
Beehave wrote:
Thu Mar 29, 2018 4:10 am
And a follow-on question - - - If there is a difference between Portfolio A and B's performance based on relative volatility, would having more diversely variable assets in the fund increase the delta between A and B? Specifically, would adding a 60/40 component of international stocks and bonds to Portfolio A and to Portfolio B tend to further increase or decrease the difference in performance (or is it not possible to determine)?
Again, hard to say because of no guarantees in real life. If you posit that the asset you're adding has the same return over a given period, then yes but this ends up being an a posteriori guarantee, where it's always good to buy the depreciated asset because it's known to bounce right back.

Here's a thought experiment to illustrate this. Suppose that every year you take 10% of your portfolio and flip a coin for it with a like-minded investor. This is a high-volatility, zero-average-return "asset" that's obviously not correlated with anything. Do you think adding it to a portfolio improves any of its measures? (I think it hurts your risk/reward grievously). Do you think that if you were to take two such coin-flip subportfolios and rebalance between them that would improve things even further? On the rationale that the two coin series are known to have similar returns over time, so when one is down it's probably going to rebound? (also known as the Gambler's Fallacy!).

So this is a cautionary tale about adding "uncorrelated volatility" just for the sake of rebalancing with it. And it's exactly how I feel about currency risk in international bonds, for example -- it's a large, volatile component of their return with an expected return of zero. I don't need that in my portfolio. But in int'l stocks that risk is a smaller (and diminishing) component and the diversification aspect is more important for a range of allocations.

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Re: Explain one more time how balance funds work

Post by fortyofforty » Sat Mar 31, 2018 3:34 pm

ogd wrote:
Sat Mar 31, 2018 2:20 pm
So this is a cautionary tale about adding "uncorrelated volatility" just for the sake of rebalancing with it. And it's exactly how I feel about currency risk in international bonds, for example -- it's a large, volatile component of their return with an expected return of zero. I don't need that in my portfolio. But in int'l stocks that risk is a smaller (and diminishing) component and the diversification aspect is more important for a range of allocations.
Interesting that Vanguard went "all in" on international bonds for its LifeStrategy family. I'm not sure the move was necessary, but someone at Vanguard sure did (or at least "helpful" or "beneficial" if not strictly necessary).
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Re: Explain one more time how balance funds work

Post by Beehave » Sat Mar 31, 2018 8:09 pm

ogd wrote:
Sat Mar 31, 2018 2:20 pm
Beehave wrote:
Thu Mar 29, 2018 4:10 am
Portfolio A = 60% Total US stock fund, 40% Total US Bond rebalanced once a year
Portfolio B = 60/40 Total US Stock and Bond fund rebalanced daily (or however frequently the Vanguard 60/40 Balanced fund rebalances)

Would it be true that if one of the assets (say stocks) steadily outperformed the other over the course of the year that Portfolio A would outperform Portfolio B,
Yes. Portfolio A achieved this by having more stocks on average, i.e. taking more risk for more reward (in this case). It's the usual tradeoff and not a problem with rebalancing. Like in my email above, if you say that a larger stock allocation is appropriate after stocks have gone up, you have to justify it and it rather looks like market timing.
Beehave wrote:
Thu Mar 29, 2018 4:10 am
whereas if instead there were high volatility in one asset (say in stocks) but not the other, then Portfolio B would outperform Portfolio A?
This is hard to say without knowing the timing and the returns. If stocks ended up returning the same or less than bonds over the high-volatility period I think it's likely (perhaps even guaranteed, haven't thought the math through) that the rebalanced portfolio did better. This wasn't magic either -- it simply bought an asset that is known to rebound in our scenario, or sold it before it's known to drop back down. In real life we don't have the luxury of knowing this in advance, so the real reason to rebalance is to stay on track with our chosen allocation.
Beehave wrote:
Thu Mar 29, 2018 4:10 am
And a follow-on question - - - If there is a difference between Portfolio A and B's performance based on relative volatility, would having more diversely variable assets in the fund increase the delta between A and B? Specifically, would adding a 60/40 component of international stocks and bonds to Portfolio A and to Portfolio B tend to further increase or decrease the difference in performance (or is it not possible to determine)?
Again, hard to say because of no guarantees in real life. If you posit that the asset you're adding has the same return over a given period, then yes but this ends up being an a posteriori guarantee, where it's always good to buy the depreciated asset because it's known to bounce right back.

Here's a thought experiment to illustrate this. Suppose that every year you take 10% of your portfolio and flip a coin for it with a like-minded investor. This is a high-volatility, zero-average-return "asset" that's obviously not correlated with anything. Do you think adding it to a portfolio improves any of its measures? (I think it hurts your risk/reward grievously). Do you think that if you were to take two such coin-flip subportfolios and rebalance between them that would improve things even further? On the rationale that the two coin series are known to have similar returns over time, so when one is down it's probably going to rebound? (also known as the Gambler's Fallacy!).

So this is a cautionary tale about adding "uncorrelated volatility" just for the sake of rebalancing with it. And it's exactly how I feel about currency risk in international bonds, for example -- it's a large, volatile component of their return with an expected return of zero. I don't need that in my portfolio. But in int'l stocks that risk is a smaller (and diminishing) component and the diversification aspect is more important for a range of allocations.
Thanks ogd! I really appreciate the thoughtful reply. I will need to re-read it all to fully digest it - - but the thought-experiment stands out as a piece of science and art. I will think about it seriously - - but I in case you are familiar with the movie Animal House, I hope you'll enjoy a thought that occurred to me when I read it, which was that the whole market is (kind of) like a 10% up or down annual bet you're making with other buyers and sellers of stock. And to the extent that's true it reminded me of the following from Animal House, I believe spoken by Otter:

"...For if you do, then shouldn't we blame the whole fraternity system? And if the whole fraternity system is guilty, then isn't this an indictment of our educational institutions in general? I put it to you, Greg - isn't this an indictment of our entire American society? Well, you can do whatever you want to us, but we're not going to sit here ..."

Anyway, I do realize that the market in the short run is a coin-toss, but that in the long run it tends to go up, so if you are a long-term investor you are not intending to be doing coin-tosses, but rather to profit in the long term through intelligent patience. Again, thanks for your thoughtful reply!

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