This is brilliantly put. If you’re not willing to maintain your stock allocation during the bad times via rebalancing, you’re taking too much risk.longinvest wrote: ↑Sat Sep 26, 2020 10:45 amThanks RadAudit for reminding me of that specific thread. On it I had a post detailing the calculations to select a sensible asset allocation for the portfolio and then staying the course by rebalancing it.
For the benefits of this thread's readers, here are the key points I made on that thread:
longinvest wrote: ↑Sat Dec 14, 2019 7:11 pm Those who claim that not rebalancing a portfolio is "less risky" than rebalancing it are almost always guilty of comparing portfolios which had differing average asset allocations over the comparison period.
Why is this important? Because, instead of not rebalancing a portfolio, an investor should lower the allocation to stocks BEFORE the downturn to the level of risk that the investor is really willing to accept, and then the investor should rebalance the portfolio. I've shown this in the following posts:I strongly encourage readers to take the time to read both of these posts.longinvest wrote: ↑Wed Oct 24, 2018 10:37 am There's no reason to add bonds to a portfolio if the goal isn't to manage risk. Rebalancing is part of this. Avoiding rebalancing (or not rebalancing into stocks) to reduce losses is illogical; the same loss protection can be achieved by simply choosing a higher allocation to bonds in the first place. This will, of course, reduce the potential upside of the portfolio, but it will do so consistently. A non-rebalanced portfolio reduces potential gains at the worst of times, at the bottom of a bear market, and it increases potential losses at the worst of times, at the top of a bubble; it's an illogical approach to risk management.
Rebalancing is part of the 10th principle of the Bogleheads investment philosophy: Stay the course.Let's calculate a sensible asset allocation for an investor with a $1,000,000 portfolio allocated 55/45 stocks/bonds who is unwilling to rebalance bonds into stocks for fear of letting her portfolio shrink too much in a downturn.longinvest wrote: ↑Sun Dec 15, 2019 12:02 pm Here's an example of how to put in action the logic/mathematics contained in my previous post.
Let's take an investor with a $1,000,000 portfolio who doesn't want her portfolio to drop below $500,000. The investor considers that a potential yet low-probability catastrophic scenario for stocks is a loss of -80%.
A naive (and broken) approach would be for the investor to put $625,000 in stocks and $375,000 in bonds and not rebalance her portfolio. That's because (($625,000 - 80%) + $375,00) = $500,000. This is broken because it doesn't stand the test of logic. Portfolios aren't static. If the retiree is in retirement, she'll need to withdraw money from the portfolio. If she withdraws from bonds, the portfolio could drop lower than $500,000. If she withdraws from stocks, she'll sell them at low (and lower) prices and she might quickly run out of stocks to sell. Anyway, let's put these considerations aside and continue our example with a static portfolio from which no money is withdrawn and to which money isn't added.
The logical approach is for the investor to consider what would happen if the -80% loss of stocks spanned over 200 consecutive days, while the portfolio was rebalanced daily. The daily stock loss would be: ((1 - 80%)^(1/200) - 1) = -0.8015%. As the investor's goal is to limit the portfolio's loss to 50% over that period, the target daily portfolio loss would be: ((1 - 50%)^(1/200) - 1) = -0.3460%. As a consequence, the investor puts (-0.3460% / -0.8015%) = 43.17% of her portfolio in stocks. In other words, the investor puts $431,663 in stocks and $568,336 in bonds and won't fear regularly rebalancing her portfolio because she knows that her portfolio won't lose more than half of its value, even in a catastrophic scenario where stocks lost -80% of their value.
We'll consider that a potential yet low-probability catastrophic scenario for stocks is a loss of -80%.
Our retiree has $550,000 in stocks and $450,000 in bonds. If stocks were to lose -80% and bonds remained $450,000 (without rebalancing), the portfolio would shrink to (($550,000 - 80%) + $450,000) = $560,000 and end up with a 20/80 stock/bond allocation after the loss.
Our retiree is thus aiming to limit portfolio losses to -44% if stocks ever lost -80%. Over 200 consecutive days, a cumulative -80% loss represents a ((1 - 80%)^(1/200) - 1) = -0.8015% daily loss. and a cumulative -44% loss represents a ((1 - 44%)^(1/200) - 1) = -0.2895% daily loss. So, if our retiree allocates (-0.2895% / -0.8015%) = 35% (rounded) of her portfolio to stocks, she'll protect her portfolio against catastrophic stock losses while staying the course and rebalancing her portfolio.
The fact that our retiree is considering not to rebalanced her 55/45 stock/bond portfolio, trying to maximize potential portfolio gains when stocks are more expensive, yet she's willing to accept much lower potential portfolio gains with a smaller 20/80 stock/bond portfolio when stocks are -80% cheaper, is indicative of behavioral pitfalls. I would suggest that she simply puts her entire portfolio into Vanguard's Target Retirement Income Fund (VTINX), a globally-diversified One-Fund Portfolio with a 30/70 stock/bond allocation (close enough to 35% stocks). This way, even if stocks gradually lose a cumulative -80% over 200 days, she'll end up with a bigger portfolio ($1,000,000 X ((((1 - 0.8015%) X 30%) + 70%)^200) = $617,873) than if she kept a non-rebalanced 55/45 stock/bond portfolio, and a higher exposure (30%) to stocks once they get dirt cheap. Even better, she won't need to do anything as the fund is automatially rebalanced; she'll be able to enjoy her retirement, instead.
I don’t like this advising of retirees to go with higher stock allocations and then “solve it” by not maintaining it in the bad times.
Just my 2 cents.