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Using dividends to rebalance

Posted: Thu Mar 14, 2019 7:48 am
by Beliavsky
A working paper

Who Should Sell Stocks?
by Paolo Guasoni, Ren Liu, and Johannes Muhle-Karbe
September 21, 2017
Abstract
Never selling stocks is optimal for investors with a long horizon and a realistic range of preference and market parameters, if relative risk aversion, investment opportunities, proportional transaction costs, and dividend yields are constant. Such investors should buy stocks when their portfolio weight is too low, and otherwise hold them, letting dividends rebalance to cash over time rather than selling. With capital gain taxes, this policy outperforms both static buy-and-hold and dynamic rebalancing strategies that account for transaction costs. Selling stocks becomes optimal if either their target weight is low, or intermediate consumption is substantial.

Keywords: transaction costs, dividends, long-run, portfolio choice
JEL Classification: G11, G12

now published in the journal Mathematical Finance says that in the presence of capital gains taxes, rebalancing is often best done gradually by investing dividends in stocks or bonds as appropriate. My comment is that when an investor has both tax-deferred and taxable accounts, the
rebalancing may be done in the tax-deferred account.

Re: Using dividends to rebalance

Posted: Thu Mar 14, 2019 12:08 pm
by livesoft
So the trivial result is that one should not pay any costs (taxes, commissions, fees) to rebalance. That's good advice and easy to do. I did not read the paper because I would have to register to see it.

But one should not pay any costs (taxes, commissions, fees) to do any of their investing nowadays anyways.

Re: Using dividends to rebalance

Posted: Thu Mar 14, 2019 12:30 pm
by Beliavsky
livesoft wrote:
Thu Mar 14, 2019 12:08 pm
So the trivial result is that one should not pay any costs (taxes, commissions, fees) to rebalance. That's good advice and easy to do. I did not read the paper because I would have to register to see it.

But one should not pay any costs (taxes, commissions, fees) to do any of their investing nowadays anyways.
Slides about the paper are available here without registration. For people with a large fraction of their assets in taxable accounts, the question of how often and how much to rebalance is a real one, because of capital gains taxes.

Re: Using dividends to rebalance

Posted: Thu Mar 14, 2019 12:38 pm
by bloom2708
In taxable, you send your dividends to the settlement fund.

You buy "toward" your desired asset mix with those dividends from the various funds.

It seems unlikely that the dividend alone (say 2%) is enough to keep you balanced through ups and downs. Maybe with a starting portfolio.

New purchases (taxable buys, Roth contributions, 401k contributions) + dividends likely doesn't keep a mature portfolio in balance either.

Re: Using dividends to rebalance

Posted: Thu Mar 14, 2019 3:12 pm
by ThrustVectoring
A source of possible error is that this strategy simply has a higher average equity allocation due to the rebalancing strategy, and outperforms on that basis over long timeframes. The way to correct is to compare rebalancing thresholds with the same expected average equity allocation across different strategies. If the buy-only rebalancing leads to 2% higher equity allocations than standard rebalancing, then you should compare the results of 58% stock dividend-rebalancing to 60% stock standard rebalancing.

On a more practical note, this is the rebalancing strategy that M1 Finance automates for you.

Re: Using dividends to rebalance

Posted: Thu Mar 14, 2019 3:49 pm
by livesoft
Beliavsky wrote:
Thu Mar 14, 2019 12:30 pm
For people with a large fraction of their assets in taxable accounts, the question of how often and how much to rebalance is a real one, because of capital gains taxes.
While this is absolutely true (and is true for me), tax-loss harvesting has helped me avoid capital gains taxes since about the year 2000. :(

Kitces had an article showing that even a little bit of turnover (say 10%) in a taxable account can pretty much mess up performance. He did not take into account tax-loss harvesting nor rebalancing in tax advantaged accounts. This might be that article.

The bottom line is still: Don't pay taxes, fees, nor commissions to rebalance if you can possibly help it. And that extends to just plain ol' investing as well.

Re: Using dividends to rebalance

Posted: Thu Mar 14, 2019 8:28 pm
by Earl Lemongrab
It's not really an earth-shattering proposal. I think a number of us do that. It works well with the 5/25 rebalancing strategy, because there's never a "rebalance day". By directing distributions to lagging assets, you generally rebalance continually. I haven't needed to sell something to buy something else in a long time. It's pretty easy to keep things within the ranges.

Re: Using dividends to rebalance

Posted: Thu Mar 14, 2019 8:46 pm
by AlohaJoe
The paper notes that there are two scenarios where its strategy is inferior:
  • When the investor is conservative. (Which probably applies to the vast majority of Bogleheads....) A conservative investor is one who has 50% of less of their portfolio in stocks. If you are 50/50 or 40/60 then you are conservative and the strategy doesn't work for you.
  • When you consume the dividends. They note that the dividend yield has to be "high enough" for the strategy to work. If you are spending the dividends (because, say, you are retired) then the dividends probably aren't high enough unless yields are extremely high or your spending is extremely low.
So the finding doesn't apply to anyone in retirement and probably to a lot of Bogleheads who are near retirement.

Re: Using dividends to rebalance

Posted: Thu Mar 14, 2019 9:07 pm
by retiringwhen
AlohaJoe wrote:
Thu Mar 14, 2019 8:46 pm
The paper notes that there are two scenarios where its strategy is inferior:
  • When the investor is conservative. (Which probably applies to the vast majority of Bogleheads....) A conservative investor is one who has 50% of less of their portfolio in stocks. If you are 50/50 or 40/60 then you are conservative and the strategy doesn't work for you.
  • When you consume the dividends. They note that the dividend yield has to be "high enough" for the strategy to work. If you are spending the dividends (because, say, you are retired) then the dividends probably aren't high enough unless yields are extremely high or your spending is extremely low.
So the finding doesn't apply to anyone in retirement and probably to a lot of Bogleheads who are near retirement.
Actually, if you look at your portfolio as taxable vs. non-taxable/tax-deferred. i think it is safe to say that this strategy can be applied in the taxable account to reduce friction while rebalancing out of stocks in the lowest cost place such as IRAs, possibly considering the transaction costs as well. So in other words, do what livesoft said :D

Re: Using dividends to rebalance

Posted: Thu Mar 14, 2019 9:16 pm
by JustinR
Uh...duh?

Someone had to write a paper about this?

Re: Using dividends to rebalance

Posted: Fri Mar 15, 2019 4:43 pm
by Dale_G
Publish or perish. No one seems particularly concerned about originality. The authors may have been peeking at my notes from 40 years ago.

Dale