Tolerance for "rebalancing risk" in retirement

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Browser
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Tolerance for "rebalancing risk" in retirement

Post by Browser »

We've heard of risk tolerance, which is thought of as an investor's capacity for tolerating portfolio losses in "worst case" scenarios. For example, in 2008 a portfolio allocated 60% US stocks / 40% US bonds suffered an annual loss of about 20%. For retirees taking a 4% withdrawal that year, their portfolio drawdown with a 60/40 allocation would have been 24% including the distribution.

Studies of portfolio survival during retirement by Bengen and others have demonstrated that, at least in the past, portfolios with a substantial allocation to stocks of 50% - 90% or so have managed to last for retirement horizons of 30 years. This was the case even including retirement periods during which there were large equity drawdowns. The results of these studies demonstrate that if an investor can stay the course with a high allocation to stocks, which they rebalance annually, their portfolio is likely to survive the downturns and last throughout retirement with withdrawal rates in the neighborhood of 4% (adjusted for inflation annually).

However, I've never seen anything mentioned about just how difficult it might be to stay the course and rebalance during severe market downturns. So, I decided to take a look at what the situation might have been in 2008, which was the last severe drawdown in which stocks lost about 37%. Here's what I found:

For a retiree with a portfolio of US stocks and bonds, in 2008, including the 4% distribution, the stock portion of their portfolio returned -39.6% while the bond portion returned -0.9%.

In order to rebalance his portfolio to the target allocation at the end of 2008, the investor would have needed to liquidate bonds in order to buy stocks. For various allocations, here's how much of his bond holdings he would have needed to sell in order to buy stocks to rebalance to his initial target allocation (stocks/bonds):

60%/40%: sell 35% of bond holdings to buy stocks
70%/30%: sell 50% of bond holdings to buy stocks
80%/20%: sell 65% of bond holdings to buy stocks

As you can see, the retiree with a high equity allocation is faced with a rock and a hard place if a drawdown of the 2008 magnitude were to occur, which is certainly always a possibility. He either has to sell down a very large chunk of his safe bond holdings to buy more stocks, or he has to quit on his initial allocation -- which he presumably chose because his financial advisor told him that's what he needed to assure that his portfolio would last through his retirement, and the results of his "risk tolerance" questionnaire indicated he could probably handle any downturns that might show up. However, nobody told him what he might actually have to do at some point in order to "stay the course". Selling down 35, 50, or 65% of your bedrock bond holdings to buy stocks might not have been mentioned as a possibility. I would call this "rebalancing risk"; i.e., the risk that you will not be able to stick to your portfolio allocation during large drawdowns because of the drastic portfolio adjustments that might be required to do it. Maybe we should add this to the pantheon of investment "risks", particularly for retirees who decide on large stock allocations in their retirement portfolios.
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Dale_G
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Re: Tolerance for "rebalancing risk" in retirement

Post by Dale_G »

Browser, you picked the calendar year of 2008, but I'll pick some other dates that stick in my mind and paint even a bleaker picture.

The S&P500 peaked at a closing high of 1563 on October 9, 2007
The S&P500 reached a closing low of 677 on March 9, 2009
The decline was 886 points - or 57%. Add about about 3% dividends over 17 months, I'll call the decline 54%.

And yes, I "spent" more that 30% of my safe bond holdings to buy the equities that were in decline.

The quote below is from a Bogleheads post I made 9 days before the market low.
Sun Mar 01, 2009 3:53 pm

Just doing the same old thing I've been doing for more than 20 years.
As the markets ebb and flow, I either buy or sell equities to maintain my asset allocation.

It wasn't much fun to sell equities and buy bonds when the equity markets were soaring, but it sure did build up the bond pile.

Now I am selling the bonds and buying much cheaper equities. That isn't much fun either!
My point then, and now, is that if you rebalance out of equities when equity markets are up, you should be willing to bite the bullet and rebalance into equities when equities are in the dumps. It is definitely not fun in either direction.

I know what I did do with a more than 50% decline. What I can't say is what I would have done if equities had declined another 50% from the lows of March 9. That would have been even less fun. Maybe time for the infamous plan "B".

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Re: Tolerance for "rebalancing risk" in retirement

Post by Confuscious »

Buying equities at a discount during a recession sounds like a great way to double your money when the market recovers. If I was in retirement I would be happy to sell 65% bonds so long as I had enough fixed income to last an extended bear of 5-7 years.
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Re: Tolerance for "rebalancing risk" in retirement

Post by The Wizard »

I was still employed in the 2007-2009 timeframe which was in my pre Boglehead days as well. I'm retired now.

If/when it happens again, it's entirely possible I might not rebalance fully back to my nominal 50/50 AA. I use bands to rebalance and only back to the edge of the band. Lately, I've been holding to 54% to 53% stocks. In a crash, I might just rebalance back to 47% stocks.
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Re: Tolerance for "rebalancing risk" in retirement

Post by telemark »

I would expect that most investors with 80/20 or 70/30 allocations are still a long way from retirement. If not, the risk comes not from rebalancing but from being too heavy in stocks.
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Re: Tolerance for "rebalancing risk" in retirement

Post by lazyday »

If I get around to it, maybe I'll find historical bond and equity yield, such as on Jan 1 2008 and 2009.

Equity yield could be current dividend yield or 1/CAPE. Bond could be TIPS yield or real yield of nominals.

Selling several years of spending in bonds to buy falling equities might be easier (and maybe safer) if equity has a high expected return.
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Re: Tolerance for "rebalancing risk" in retirement

Post by richard »

Confuscious wrote:Buying equities at a discount during a recession sounds like a great way to double your money when the market recovers. If I was in retirement I would be happy to sell 65% bonds so long as I had enough fixed income to last an extended bear of 5-7 years.
"when the market recovers" implies a higher degree of certainty in an adequate recovery than may be warranted, as does the "extended bear of 5-7 years". The problem is that the market may not recover as quickly or as completely as is hoped.

We don't have enough useful historical data to have a high degree of confidence in these things and there's no reason to believe them from first principles. They seem contrary to the idea that the equity premium is a reward for risk. Not much risk if recovery is assured.
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Re: Tolerance for "rebalancing risk" in retirement

Post by nisiprius »

1) I'm ashamed of it but the fact is that I was not able to bring myself to place an order to buy stocks during 2008-2009. What we actually decided to do was to do was, literally nothing.

2) At that time, a significant fraction of our stocks was in the Vanguard Balanced Index Fund. I justified my inaction at the time, in part, by saying to myself "well, most of our portfolio is getting rebalanced even if I take no action).

3) Analysis of the behavior of that fund shows clearly that during the 2008-2009 downturn, the effect of rebalancing in that fund was not either harmful or beneficial. It was about as close to zero, no overall effect, as you ever see in anything in investing. Depending on how you measure, there might have been a $60 "rebalancing bonus" on a $10,000 holding.

4) There have been discussion of what I call "the possibility of rebalancing suckage," the theoretical effect that occurs when stocks just keep dropping and dropping and dropping and during the drop the apparent effect is that one is constantly "throwing good money after bad." This actually does occur but it is surprisingly small. $10,000 in Vanguard Total Stock Market Index Fund lost $5,206 between 1/1/2008 and 3/6/2009. In Balanced Index, $3,390. If it had dropped 60% as far as Total Stock, it would have dropped only $3,124. Thus, the effect of rebalancing was to make worsen the number-of-dollars drawdown by 8%. It's interesting, though, since we often say "rebalancing is for risk control," to observe that during a severe crash a rebalanced portfolio actually fluctuates more than an unrebalanced one.

5) The reason why it mattered so little is a good illustration of a mental trap almost everyone falls into when thinking about rebalancing. The fantasy is that the investor who rebalances, say during 2008-2009, will be snapping up lots of cheap stocks. This fantasy is only true if the purchases are concentrated at the dip, that is to say if the investor successfully times the market. You think of 2008-2009 and you think rebalancing means buying stocks when the Dow was $6-to-$8,000.

In reality, if the rebalancing is done on schedule, your stock purchases on the way down are a series of dots outlining the dip... with the Dow at 14,000, 12, 10, 8, 6... and another series of dots outlining the rise... 8, 10, 12, 14... and to figure out your overall rebalancing bonus you have to total one set of dots and subtract it from the other, and those totals are almost equal. Imagine you are drawing the Dow as a dotted line, and try to imagine pairing each dot representing a purchase during the downturn with a corresponding dot representing a sale on the upturn. It is not as if all you did was make a large purchase when the Dow was $6,000.

6) The mental error of thinking that effect of rebalancing is similar to making a big purchase at the bottom is a huge error. The actual effect of rebalancing between assets that are doing a hairy fractal dance, with big fluctuations having little fluctuations (upon their backs to bite 'em) is beyond my personal ability to appreciate intuitively. That's really dangerous because when we can't intuit quantitative things accurately, we tend to intuit them anyway. It doesn't help when a chorus of salespeople is chanting stuff like "the trend is your friend" into your ear.

So my conclusion is that rebalancing is just not the great big hairy deal people sometimes make it out to be; that you probably should keep on rebalancing, even during a downturn; that people--ME--often lack the risk tolerance to do so--but failing to do so is not a big risk, because rebalancing isn't a big deal.

Of course, if you believe in the rebalancing bonus and believe that it is immense, and that holding a multi-asset portfolio of volatile uncorrelated assets and rebalancing frequently is manufacturing large amounts of alpha for you, well then... you believe something different from what I believe.
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Re: Tolerance for "rebalancing risk" in retirement

Post by Rob Bertram »

How real is this for anyone? Most people are either accumulating or decumulating. If accumulating, people are hopefully rebalancing with contributions and buying stocks while they're cheap, super cheap, and on fire sale. If decumulating, people will just spend down the bond portion at a higher percentage.
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Re: Tolerance for "rebalancing risk" in retirement

Post by knpstr »

richard wrote: They seem contrary to the idea that the equity premium is a reward for risk.

Is not the "risk" of equities short-term volatility?
richard wrote: Not much risk if recovery is assured.
Has it not been demonstrated that long-term equities are the best vehicle for investment?

The "risk" is in the time-frame. Will equities recover by the time you need them?
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Re: Tolerance for "rebalancing risk" in retirement

Post by Svensk Anga »

knpstr wrote: The "risk" is in the time-frame. Will equities recover by the time you need them?
If you are a Japanese investor with home-market bias, probably not.

In one of his books, Bill Bernstein gives the example of rebalancing during the early 1930's. Anyone who thinks they can rebalance during retirement needs to think through that scenario.

I like the LMP + RP heading into retirement. No rebalancing required.
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Re: Tolerance for "rebalancing risk" in retirement

Post by TheTimeLord »

So far I don't rebalance, I reallocate based on any changes to my personal situation or strategy. Otherwise I just let the ponies run.

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Re: Tolerance for "rebalancing risk" in retirement

Post by Confuscious »

richard wrote:
Confuscious wrote:Buying equities at a discount during a recession sounds like a great way to double your money when the market recovers. If I was in retirement I would be happy to sell 65% bonds so long as I had enough fixed income to last an extended bear of 5-7 years.
"when the market recovers" implies a higher degree of certainty in an adequate recovery than may be warranted, as does the "extended bear of 5-7 years". The problem is that the market may not recover as quickly or as completely as is hoped.

We don't have enough useful historical data to have a high degree of confidence in these things and there's no reason to believe them from first principles. They seem contrary to the idea that the equity premium is a reward for risk. Not much risk if recovery is assured.

Agreed. However are there not any assumptions that can be warranted? In order to plan for the future we must make some sort of prediction, right?

We are living in a massive industrial/technical/?? Revolution and it could change any day. If the market decides not to recover after a crash then things will be relative & we will all be in the same boat. As long as we have food over our head and a roof on our plate :) Everything else is a luxury. Having some gold in case of an emergency might be an option in the unknown scenario.
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Re: Tolerance for "rebalancing risk" in retirement

Post by knpstr »

TheTimeLord wrote:So far I don't rebalance, I reallocate based on any changes to my personal situation or strategy. Otherwise I just let the ponies run.
Nice chart! Found the article, to put that chart in perspective... from the article:

"More often than not, it [rebalancing] was a winner, but when it lost out, it often lost by a large amount. On average, Nolan found, rebalancing subtracted an annual 0.15% from results."
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Re: Tolerance for "rebalancing risk" in retirement

Post by Browser »

I agree with not rebalancing, except when maybe my stock allocation gets to be out of sight - then I might take some off the table. Fortunately for me, Mr. Market has made sure that hasn't happened during this century. If stocks went into the tank and I thought I needed to maintain 70% or more in equities, I know I wouldn't have the nerve to decimate my safe bond stash to rebalance, so why pretend that I'm following a disciplined "rebalancing strategy?" Lets' get real. Nobody actually does this stuff when the rubber is on the road do they? It's mostly textbook stuff.
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Re: Tolerance for "rebalancing risk" in retirement

Post by Rob Bertram »

I feel compelled to remind everyone that the rebalancing penalty isn't really a penalty. We pick an asset allocation based on a general sense of risk. Saying that a 50/50 portfolio left unbalanced would drift to 60/40 and would yield an extra 0.15% return is ignoring the fact that your risk drifted as well. If you were okay with the higher level of risk with a 60/40 portfolio, why not start there instead, keep it balanced, and get 0.35% better returns than a balanced 50/50 portfolio?
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Re: Tolerance for "rebalancing risk" in retirement

Post by TheTimeLord »

Rob Bertram wrote:I feel compelled to remind everyone that the rebalancing penalty isn't really a penalty. We pick an asset allocation based on a general sense of risk. Saying that a 50/50 portfolio left unbalanced would drift to 60/40 and would yield an extra 0.15% return is ignoring the fact that your risk drifted as well. If you were okay with the higher level of risk with a 60/40 portfolio, why not start there instead, keep it balanced, and get 0.35% better returns than a balanced 50/50 portfolio?
If you had a 50/50 AA that drifted to 60/40 does your risk really change in terms of the dollar floor or is this just a percentage dance. So you start with a 50/50 AA ($500,000/$500,000) with your million which means you can let it drop to $750,000 in dollar terms if stocks drop 50%. Now it drifts to 60/40 AA ($750,000/$500,000) so risk in dollar terms is now $875,000 which seems safer to me than having $750,000. Looking for comments on this logic.
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Re: Tolerance for "rebalancing risk" in retirement

Post by randomguy »

Rob Bertram wrote:I feel compelled to remind everyone that the rebalancing penalty isn't really a penalty. We pick an asset allocation based on a general sense of risk. Saying that a 50/50 portfolio left unbalanced would drift to 60/40 and would yield an extra 0.15% return is ignoring the fact that your risk drifted as well. If you were okay with the higher level of risk with a 60/40 portfolio, why not start there instead, keep it balanced, and get 0.35% better returns than a balanced 50/50 portfolio?
If you have 25x in savings and you want 12.5 years in bonds, starting at 50/50 makes sense. If you don't want 15 years in bonds, staying there as the portfolio goes up could make sense. But yeah I am actually impressed that rebalancing did so well. I would have expect selling off a high performing asset to buy a lower one to result in bigger losses than what shows up given the risk creep over the years.
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Re: Tolerance for "rebalancing risk" in retirement

Post by Dandy »

I retired in 2008 so in a sense I've been there. I was 60 and could collect a moderate pension but my nest egg was taking a severe hit even though I entered the downturn with about 55% in equities. In the accumulation stage it was relatively easy to change future contributions, company match and even do some exchanges in a down market. No problem with the market plunge in 2000-01 when I was employed.

I decided gradually rebalance via DCA starting before the end of 2008 and on occasion added a but more. I was determined to not let my portfolio go much farther under since I had a long retirement ahead and there were literally no jobs of any kind available.

I feel in retirement rebalancing is/should be different. At a certain point you want to preserve the safer assets needed for living expenses so more caution is warranted. You may have to forego rebalancing for awhile or not rebalance up to previous targets. I think that the relatively quick and robust equity recovery has made that approach out of favor. Retirees who did fully rebalanced have been amply rewarded.

But, there is no guarantee that recovery will be quick or robust. You could face a number of years having the "safe" portion of your portfolio taking double hits- 1 to fund living expenses and 2. to rebalance. At some point you would see your safe portfolio getting out of your comfort zone. The question is not if you will stop fully rebalancing only when. If you stop too early you miss some upside, if you wait until it is too late you put your retirement funding at greater risk.

The key to me is preserving the assets need to fund retirement to say age 90 - not maintaining a target equity vs bond allocation.
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Re: Tolerance for "rebalancing risk" in retirement

Post by lazyday »

Say our portfolio is 60% global equity and 40% TIPS. Our coward’s 40 year SWR includes
1/40 * TIPS
½ TIPS yield * TIPS
½ equity dividend yield * equity

Today this totals to roughly 1+.2+.75 = 1.95%

If stocks fall 10% but dividends aren’t cut, then if we don’t rebalance, our SWR is unchanged. We still get equity SWR of .75% of the original portfolio:
.5 * 2.78% (yield is higher with price lower) * .54.

But rebalancing will reduce the coward’s SWR, because we are selling TIPS of higher SWR than equity.

We might choose to wait to rebalance until stocks have yield (after cuts) higher than 2/40 + TIPS yield, which today would be nearly 6%. Then rebalancing would increase SWR.
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Re: Tolerance for "rebalancing risk" in retirement

Post by Erwin »

My view is that the best way to face a 2008 crisis is to hold an investment, i.e., fund or ETF with a build in asset allocation that meets your needs. This way you need to do nothing.
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Re: Tolerance for "rebalancing risk" in retirement

Post by Rob Bertram »

TheTimeLord wrote:
Rob Bertram wrote:I feel compelled to remind everyone that the rebalancing penalty isn't really a penalty. We pick an asset allocation based on a general sense of risk. Saying that a 50/50 portfolio left unbalanced would drift to 60/40 and would yield an extra 0.15% return is ignoring the fact that your risk drifted as well. If you were okay with the higher level of risk with a 60/40 portfolio, why not start there instead, keep it balanced, and get 0.35% better returns than a balanced 50/50 portfolio?
If you had a 50/50 AA that drifted to 60/40 does your risk really change in terms of the dollar floor or is this just a percentage dance. So you start with a 50/50 AA ($500,000/$500,000) with your million which means you can let it drop to $750,000 in dollar terms if stocks drop 50%. Now it drifts to 60/40 AA ($750,000/$500,000) so risk in dollar terms is now $875,000 which seems safer to me than having $750,000. Looking for comments on this logic.
randomguy wrote:If you have 25x in savings and you want 12.5 years in bonds, starting at 50/50 makes sense. If you don't want 15 years in bonds, staying there as the portfolio goes up could make sense. But yeah I am actually impressed that rebalancing did so well. I would have expect selling off a high performing asset to buy a lower one to result in bigger losses than what shows up given the risk creep over the years.
It sounds like these are two different versions of a bucket strategy (http://www.bogleheads.org/wiki/Buckets_of_Money). There's noting wrong with that strategy, but it has variable (increasing) risk as the fixed-income buckets shrink as a percentage of the portfolio.

My only point is that risk increases with the strategy, and comparing increasing-risk to a fixed-risk strategy makes people think that they are both fixed-risk.
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Re: Tolerance for "rebalancing risk" in retirement

Post by Sidney »

Isn't this generalizable as risk of not sticking to your plan. For example, if your plan is to maintain fixed income with an average duration of 5 years and you panic and move to cash or reduce duration to 2 years ... you have made the same error. Or if you start out with 50% of your equity in small value and then panic and bail out due to tracking error. etc. etc. I think more people overestimate their tolerance for risk than underestimate it -- just a hunch.
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Re: Tolerance for "rebalancing risk" in retirement

Post by Christine_NM »

nisiprius wrote:$10,000 in Vanguard Total Stock Market Index Fund lost $5,206 between 1/1/2008 and 3/6/2009. In Balanced Index, $3,390. If it had dropped 60% as far as Total Stock, it would have dropped only $3,124.
Some (if not all) of this difference might be the effect of the slightly higher ER of Balanced Index rather than a market crash/rebalancing effect. Maybe the ~$300 difference was paid to get the rebalancing done every day.

I appreciate the analysis and wholeheartedly agree that our mental models of how big and little hairy fractal dances work are woefully inadequate. Yet we soldier on.
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Re: Tolerance for "rebalancing risk" in retirement

Post by Browser »

Rob Bertram wrote:I feel compelled to remind everyone that the rebalancing penalty isn't really a penalty. We pick an asset allocation based on a general sense of risk. Saying that a 50/50 portfolio left unbalanced would drift to 60/40 and would yield an extra 0.15% return is ignoring the fact that your risk drifted as well. If you were okay with the higher level of risk with a 60/40 portfolio, why not start there instead, keep it balanced, and get 0.35% better returns than a balanced 50/50 portfolio?
I'm among those who don't agree that risk drifts with returns and agree with William Sharpe that risk is a function of where you are relative to what all investors are holding in the aggregate. For example, if all invested capital were distributed 50% in equities and 50% in bonds and you have a 50/50 allocation, then your portfolio has the risk level of the "average" investor. If your stock allocation drifts to 60% then, guess what? It's because all invested capital is now probably distributed close to 60% in equities and 40% in bonds. If you do nothing, you still hold a portfolio with the average risk level. Now you might feel that the markets have it wrong, and decide to rebalance back to where you started at 50% equities; but now you hold a portfolio that is less risky than the capital markets are saying is average risk. At some point that you might think capital markets have it wrong; then you can choose to be a contrarian and a market timer and "rebalance." If it feels like the right thing to do then it probably is, for you anyway. But it's you vs. Mr. Market.
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Re: Tolerance for "rebalancing risk" in retirement

Post by randomguy »

Rob Bertram wrote: It sounds like these are two different versions of a bucket strategy (http://www.bogleheads.org/wiki/Buckets_of_Money). There's noting wrong with that strategy, but it has variable (increasing) risk as the fixed-income buckets shrink as a percentage of the portfolio.

My only point is that risk increases with the strategy, and comparing increasing-risk to a fixed-risk strategy makes people think that they are both fixed-risk.
I prefer to call it the rising stock allocation in retirement plan. Then you are one of the cool kids following a current trend the literature:)
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Re: Tolerance for "rebalancing risk" in retirement

Post by The Wizard »

Several posts back, Nisiprius mentions the oft-heard "rebalancing is for risk control".
True, but if your nominal 60/40 AA drops to 50/50 due to stock market down-trending, well then, your risk level going forward is now LOWER than previously.
Well, unless you rebalance back to 60/40, thus increasing your risk back to the original level.

So it comes down to: having "lost" a decent chunk of your nest egg in the early downturn, is it now a good time to increase your risk?
Can we say Nerves of Steel?

I suspect it's easier to play this game for younger employed folks, not people in retirement...
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Re: Tolerance for "rebalancing risk" in retirement

Post by Browser »

Here's another perspective. When you decide on an AA, it's presumably based on your expectations regarding future returns, which include returns attributable to the equity risk premium. Let's say you expect the ERP to be about 4% and the bond return to be about 2%. So you figure total compounded return will be comprised of a CAGR of 6% and 2% from bonds. Based on that you decide to go 50% in stocks and 50% in bonds with an expectation of about 4% annually-compounded long term return with an acceptable risk level.

But the 4% long term compound return from your starting point assumes that you continue to own the same number of shares in stocks and bonds that you started with, not buying and selling shares as you go along. Returns will be "noisy" over time; sometimes high and sometimes low. What automatic rebalancing does is to have you either selling some of your original shares or buying more based on the gyrations in returns. If you do that, then you've violated the assumptions on which your original return expectations were based. Nobody ever said your expected long-term returns were going to be a smooth ride. There will be times when the returns are higher than the expected trend and sometimes lower. Staying the course means not selling or buying based on the short run.

From that perspective, would I ever buy more shares or sell shares? Only if my need, ability, or willingness to take risk has changed. For example, if stocks have been on a run and now I'm "richer" than I was before I might decide to sell some shares because I don't need to take as much risk as before. Or, if stocks have tanked and my portfolio has shrunk my need to take risk might have just increased because I have to try to increase expected returns; so I might decide to buy more stocks. This has nothing to do with "rebalancing". If there has been no change in my need, ability, or willingness to assume risk then I should not do anything and continue to own the original shares I started with. For most people, this will be most of the time.
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Re: Tolerance for "rebalancing risk" in retirement

Post by sambb »

When looking at historical threads, i t appears that several people did not rebalance in, as the market dropped >40%.

Best to be in a nice life strategy fund and avoid all of these issues.
texasdiver
Posts: 3935
Joined: Thu Jun 25, 2009 12:50 am
Location: Vancouver WA

Re: Tolerance for "rebalancing risk" in retirement

Post by texasdiver »

My wife and I were mostly in Wellington and Target Retirement 2035 before the crash and we are still chugging away basically the same funds today.

Rebalancing? I let Vanguard do it for me.
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