Never Ever Rebalance Bonds into Stocks?

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Steve Reading
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Re: Never Ever Rebalance Bonds into Stocks?

Post by Steve Reading »

longinvest wrote: Sat Sep 26, 2020 10:45 am
RadAudit wrote: Fri Sep 25, 2020 6:32 pm (Thank you longinvest viewtopic.php?t=297459)
Thanks 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: It's worth restating the conclusion:
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.
I strongly encourage readers to take the time to read both of these posts.

Rebalancing is part of the 10th principle of the Bogleheads investment philosophy: Stay the course.
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.
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.

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.
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.

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.
"... so high a present discounted value of wealth, it is only prudent for him to put more into common stocks compared to his present tangible wealth, borrowing if necessary" - Paul Samuelson
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Re: Never Ever Rebalance Bonds into Stocks?

Post by KlangFool »

longinvest wrote: Sat Sep 26, 2020 10:45 am

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%.


longinvest,

I am totally confused. Would you mind use the following set of numbers and work out what the correct AA would be?


A) Portfolio size = 1.5 million


B) The total portfolio should not drop below 300K.


C) Using the same set of assumption of continuous rebalancing and the stock could drop 80%.


Thanks in advance.


KlangFool
longinvest
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Re: Never Ever Rebalance Bonds into Stocks?

Post by longinvest »

KlangFool wrote: Sat Sep 26, 2020 12:19 pm
longinvest wrote: Sat Sep 26, 2020 10:45 am

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%.


longinvest,

I am totally confused. Would you mind use the following set of numbers and work out what the correct AA would be?


A) Portfolio size = 1.5 million


B) The total portfolio should not drop below 300K.


C) Using the same set of assumption of continuous rebalancing and the stock could drop 80%.


Thanks in advance.


KlangFool
KlangFool, ($300,000 / $1,500,000) = 20%. In the context of my post, this represents a short-term -80% portfolio loss. No further calculation is needed to answer that this is a 100% stocks portfolio. Why are you asking such an obvious question?
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Re: Never Ever Rebalance Bonds into Stocks?

Post by langlands »

Uncorrelated wrote: Sat Sep 26, 2020 3:56 am
langlands wrote: Sat Sep 26, 2020 12:46 am
Thanks for a thought provoking post. I agree that if you assume stock markets are memoryless (Markov process) and that your own utility function is memoryless, then your asset allocation should depend only on your current wealth and not how you got to that wealth. But I think that's an assumption one has to make (which assuming EMH is usually an approximation one is willing to make on the stock market side). I don't think that follows from Bellman's principle of optimality. Rather, Bellman's equation assumes a Markov environment and derives the recursive substructure of the decision making process from it.

To see the merit of one way balancing or other path dependent strategies, consider a utility function that really hates stock market drops. So if this person has $100 in the stock market and the stock market drops by 50% and returns back to the same level, this person experiences significant negative utility. Usual utility functions that only take into account current wealth would not be able to model this. Bellman's equation can still be applied in this scenario, but the "state" now needs to take into account the entire trajectory and the solution is presumably much more complicated.

I think that most people in fact have such path dependent utility functions, but the economic literature rarely considers them since they don't really make sense from the point of view of homo economicus. Perhaps the behavioral finance people have looked into this. If one is self aware enough to realize that he has such a utility function, it would be hugely beneficial for wealth accumulation to eliminate the path dependency from his utility function. I used to think this is just obvious and anyone who doesn't is simply irrational. Now I'm a little more mature and realize that for most people, this is nearly impossible. Without getting into too much armchair psycho-pop, IMO it's probably much easier for INTP/INTJ personalities to modify their own utility functions by consciously realizing which parts of their utility function are purely emotional (have no material impact) and to thereby eliminate them from consideration.
Drawdown based utility functions are one of those things that sound intuitive but fail in spectacular ways. Here are some examples:

Scenario 1: the price starts at $100. There is a small intraday blip to $110 and then the price decreases to $100. It stays here for five years, then it drops to $50.
Scenario 2: same as scenario 1 without the intraday blip.

Scenario 1 undoubtedly has a larger drawdown than scenario 2 and therefore should have a lower utility. But at the same time, awarding scenario 1 a lower utility because of a intraday blip five years ago is probably not intended.

Another one. The user specifies a max drawdown of 50% and picks a 50/50 position. The portfolio drop by 40%. What should the user do? He should pick a much more conservative asset allocation, since that minimizes the probability of further drawdowns. Despite the many users insisting that they care about the max drawdown, I have never seen an user implementing such a strategy. (No, a bucket approach doesn't work).

A third problem occurs when evaluating strategies that are designed to limit drawdown. This is frequently done by running backtests, this approach pretty much always results in extremely poor parameter estimation and accidental market timing.


The conventional approach to account for emotional issues is to simply calculate the optimal portfolio and then cap the max. equity allocation. For example, with lifecycle investing, infinite leverage theoretically results in the highest expected utility, but most users cap the leverage at 2 or even avoid leverage altogether. I don't think that's irrational. I would like to have access to better tools that allow users to specify their behavioral biases and see the result ("if you specify max drawdown 50%, that results in a SWR of X. Without this rule, SWR of Y"), which hopefully enables users to decide if they really want to keep those biases. Unfortunately I don't see that happening any time soon due to the difficulty of computing such asset allocations.
Scenario 1 makes the drawdown utility look dumb (and unrepresentative of an actual human's desires) because it is an intraday blip. It can be made much more realistic by only looking at ending quarterly or annual statements. Many people have a strong aversion to sustained drawdowns. That's why you hear all these sentiments of whether the March stock crash was really a bear market- it was very short and the emotional effect on an investor was thus dampened.

Isn't scenario 2 exactly the kind of thing being discussed in this thread? After a large drop, the OP doesn't want to rebalance into stocks. That means he wants a more conservative asset allocation. Of course since most people are not versed in optimal portfolio allocation, they won't come up with the optimal strategy. But the directional nature of the change in portfolio allocation proposed matches up with a drawdown utility function.

The notion of playing with "house money" is very ingrained in many people. They keep a lifetime scorecard of how much they have won or lost "against the stock market." If they're "down" a lot against the market, they become much more risk averse than if they're "up" and playing with house money. This is independent of how much wealth they currently have and everything to do with how it got there. They could have $10 million now and if it used to be $20 million, they will want a very conservative allocation. They've been "bitten" by the market so to speak and don't want to give it any more satisfaction of their hard-earned money.

I mentioned in my post the psychological factors that come into play. I'm going to go out on a limb and guess you're INTP :happy. I am as well (well halfway between INTP/INTJ is what it came out as 10 or so years ago when i took the test). Actually, I'd be quite shocked if you weren't.

Edit: I found this paper https://stanford.edu/~boyd/papers/pdf/m ... awdown.pdf that seems to discuss path-dependent drawdown based utility functions and using dynamic programming to solve it. Could be interesting reading.
Last edited by langlands on Sat Sep 26, 2020 12:53 pm, edited 2 times in total.
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Re: Never Ever Rebalance Bonds into Stocks?

Post by KlangFool »

longinvest wrote: Sat Sep 26, 2020 12:26 pm
KlangFool wrote: Sat Sep 26, 2020 12:19 pm
longinvest wrote: Sat Sep 26, 2020 10:45 am

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%.


longinvest,

I am totally confused. Would you mind use the following set of numbers and work out what the correct AA would be?


A) Portfolio size = 1.5 million


B) The total portfolio should not drop below 300K.


C) Using the same set of assumption of continuous rebalancing and the stock could drop 80%.


Thanks in advance.


KlangFool
KlangFool, ($300,000 / $1,500,000) = 20%. In the context of my post, this represents a short-term -80% portfolio loss. No further calculation is needed to answer that this is a 100% stocks portfolio. Why are you asking such an obvious question?

longinvest,


My brain is stuck. It is not obvious to me.


My actual AA is 60/40 with a portfolio of 1.5 million. In this case, even if I do not set a FI limit of 300K on my rebalancing, I would never breach the portfolio minimum size of 300K.

Please confirm.

Thanks again.


KlangFool
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Re: Never Ever Rebalance Bonds into Stocks?

Post by longinvest »

KlangFool wrote: Sat Sep 26, 2020 12:42 pm
longinvest wrote: Sat Sep 26, 2020 12:26 pm KlangFool, ($300,000 / $1,500,000) = 20%. In the context of my post, this represents a short-term -80% portfolio loss. No further calculation is needed to answer that this is a 100% stocks portfolio. Why are you asking such an obvious question?

longinvest,


My brain is stuck. It is not obvious to me.


My actual AA is 60/40 with a portfolio of 1.5 million. In this case, even if I do not set a FI limit of 300K on my rebalancing, I would never breach the portfolio minimum size of 300K.

Please confirm.

Thanks again.


KlangFool
KlangFool, when people retire, they usually have some (current or future) pension like Social Security (possibly delayed to age 70) or a work pension. Or, when they don't, they can buy an inflation-indexed SPIA*. I usually suggest to look at the overall retirement plan instead of just considering the portfolio in isolation. Our wiki provides a simple-to-use VPW worksheet that implements an adaptive retirement plan. It can be used both during accumulation to help determine reasonable portfolio contribution amounts, and during retirement to determine reasonable portfolio withdrawal amounts. It takes into account the investor's age, salary and target retirement/financial independence age (during accumulation), portfolio size and asset allocation, as well as current and future pensions with and without cost-of-living adjustments. It conveniently informs the user of the immediate impact of a -50% stock loss on the plan. It can be instructive to look at the impact of changing the chosen asset allocation. OK. Let's go back to your question.

* Single premium immediate annuity.

Let's calculate what could happen to a $1,500,000 regularly-rebalanced 60/40 stock/bond portfolio while stocks are gradually losing -80% of their value, a Great Depression like scenario.

Note that the assumption that stocks gradually lose -80% of their value over 200 days with daily rebalancing while bond don't move is mathematically quite pessimistic. In real life, stock losses are uneven and asset prices fluctuate daily, softening cumulative losses when rebalancing. In other words, my calculations, below, are pessimistic.
  • Stocks lose ((1 - 80%)^(1/200) - 1) = -0.8015% each day
  • The 60/40 stock/bond portfolio loses: (60% X -0.8015%) = -0.4809% each day
  • Over 200 days, while stocks are losing -80% of their value, the $1,500,000 portfolio shrinks to ($1,500,000 X ((1 - 0.4809%)^200)) = $571,985
I'll add, for the benefit of readers, that it would be a mistake to compare the above portfolio to a non-rebalanced 60/40 stock/bond portfolio which would drop to (($900,000 - 80%) + $600,000) = $780,000 and have a 23/77 stock/bond allocation after the loss. If the objective is to preserve at least this amount when stocks lose -80%, repeating the calculations of my earlier post tells us that the investor should use a 40/60 stock/bond allocation instead and rebalance it.
  • Stocks lose ((1 - 80%)^(1/200) - 1) = -0.8015% each day
  • The 40/60 stock/bond portfolio loses: (40% X -0.8015%) = -0.3206% each day
  • Over 200 days, the $1,500,000 portfolio shrinks to ($1,500,000 X ((1 - 0.3206%)^200)) = $789,183 and still has a 40% exposure to stocks, which is ((40% / 23%) - 1) = 74% more than the non-rebalanced portfolio now that stocks are dirt cheap
Is this what you were looking for?
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Re: Never Ever Rebalance Bonds into Stocks?

Post by KlangFool »

longinvest wrote: Sat Sep 26, 2020 2:20 pm
KlangFool wrote: Sat Sep 26, 2020 12:42 pm
longinvest wrote: Sat Sep 26, 2020 12:26 pm KlangFool, ($300,000 / $1,500,000) = 20%. In the context of my post, this represents a short-term -80% portfolio loss. No further calculation is needed to answer that this is a 100% stocks portfolio. Why are you asking such an obvious question?

longinvest,


My brain is stuck. It is not obvious to me.


My actual AA is 60/40 with a portfolio of 1.5 million. In this case, even if I do not set a FI limit of 300K on my rebalancing, I would never breach the portfolio minimum size of 300K.

Please confirm.

Thanks again.


KlangFool
KlangFool, when people retire, they usually have some (current or future) pension like Social Security (possibly delayed to age 70) or a work pension. Or, when they don't, they can buy an inflation-indexed SPIA*. I usually suggest to look at the overall retirement plan instead of just considering the portfolio in isolation. Our wiki provides a simple-to-use VPW worksheet that implements an adaptive retirement plan. It can be used both during accumulation to help determine reasonable portfolio contribution amounts, and during retirement to determine reasonable portfolio withdrawal amounts. It takes into account the investor's age, salary and target retirement/financial independence age (during accumulation), portfolio size and asset allocation, as well as current and future pensions with and without cost-of-living adjustments. It conveniently informs the user of the immediate impact of a -50% stock loss on the plan. It can be instructive to look at the impact of changing the chosen asset allocation. OK. Let's go back to your question.

* Single premium immediate annuity.

Let's calculate what could happen to a $1,500,000 regularly-rebalanced 60/40 stock/bond portfolio while stocks are gradually losing -80% of their value, a Great Depression like scenario.

Note that the assumption that stocks gradually lose -80% of their value over 200 days with daily rebalancing while bond don't move is mathematically quite pessimistic. In real life, stock losses are uneven and asset prices fluctuate daily, softening cumulative losses when rebalancing. In other words, my calculations, below, are pessimistic.
  • Stocks lose ((1 - 80%)^(1/200) - 1) = -0.8015% each day
  • The 60/40 stock/bond portfolio loses: (60% X -0.8015%) = -0.4809% each day
  • Over 200 days, while stocks are losing -80% of their value, the $1,500,000 portfolio shrinks to ($1,500,000 X ((1 - 0.4809%)^200)) = $571,985
I'll add, for the benefit of readers, that it would be a mistake to compare the above portfolio to a non-rebalanced 60/40 stock/bond portfolio which would drop to (($900,000 - 80%) + $600,000) = $780,000 and have a 23/77 stock/bond allocation after the loss. If the objective is to preserve at least this amount when stocks lose -80%, repeating the calculations of my earlier post tells us that the investor should use a 40/60 stock/bond allocation instead and rebalance it.
  • Stocks lose ((1 - 80%)^(1/200) - 1) = -0.8015% each day
  • The 40/60 stock/bond portfolio loses: (40% X -0.8015%) = -0.3206% each day
  • Over 200 days, the $1,500,000 portfolio shrinks to ($1,500,000 X ((1 - 0.3206%)^200)) = $789,183 and still has a 40% exposure to stocks, which is ((40% / 23%) - 1) = 74% more than the non-rebalanced portfolio now that stocks are dirt cheap
Is this what you were looking for?
longinvest,


Thanks for answering my question.


The net effect for me with an AA of 60/40 and a portfolio of 1.5M is that I would never reach a minimal limit of 300K in FI under your scenario. This is assuming that I rebalance.


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Uncorrelated
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Re: Never Ever Rebalance Bonds into Stocks?

Post by Uncorrelated »

HomerJ wrote: Sat Sep 26, 2020 10:24 am
Uncorrelated wrote: Sat Sep 26, 2020 3:56 am Another one. The user specifies a max drawdown of 50% and picks a 50/50 position. The portfolio drop by 40%. What should the user do? He should pick a much more conservative asset allocation, since that minimizes the probability of further drawdowns. Despite the many users insisting that they care about the max drawdown, I have never seen an user implementing such a strategy. (No, a bucket approach doesn't work).
Why doesn't a bucket approach work? If I'm 50/50 and I specify a max drawdown of 50%, then that means stocks can drop 80%-90%, and I can still achieve my goals. If I rebalance into those stocks as they fall, and they keep falling, THAT's how it becomes possible for my drawdown to go higher than 50%

Which is precisely the point of people who don't like to rebalance into stocks near or during retirement.
The simple answer is that a bucket approach is not the asset allocation that minimizes the probability of a 50% drawdown. There are other asset allocations that have lower probability of large drawdowns and a higher certainty-equivalent consumption stream at your risk aversion.

You don't want a max drawdown of 50%. You want a stable consumption stream. You think that implementing a strategy with a maximum drawdown is a good way to obtain a stable consumption stream. You think that a bond bucket guarantees a max drawdown. Both of those thoughts are false.

To be clear, when I say "behavioral bias", I mean that you prefer a guaranteed consumption stream of $10k over a guaranteed consumption stream of $11k. A low risk tolerance is not a behavioral bias. Having desire for an income floor is not a behavioral bias.
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Re: Never Ever Rebalance Bonds into Stocks?

Post by alluringreality »

longinvest wrote: Sat Sep 26, 2020 10:45 am 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.
Is it necessarily illogical to avoid putting money into a marketable asset if someone is unwilling to accept a decline of that asset? By avoiding moving a portion of assets into a marketable asset, such as the stock market, it simply means that portion of assets does not stand to either gain or decline in value as the market changes. If it makes sense to withdraw appreciated assets or to add additional money into depreciated assets is a somewhat subjective discussion, since what people really care about is the somewhat unknown future. While I generally dislike the tone of the book, the four authors from The 3 Simple Rules of Investing suggest that it's debatable if using a set allocation and rebalancing is necessarily the only logical way of managing risk. Personally I don't think rebalancing makes sense for me, simply because savings bonds appear more in line with my considerations than marketable bonds at this time. Since savings bonds have yearly purchase limits and other terms, they don't really fit well with the idea of using a closely managed allocation and rebalancing.
Last edited by alluringreality on Sat Sep 26, 2020 3:47 pm, edited 2 times in total.
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Re: Never Ever Rebalance Bonds into Stocks?

Post by rossington »

KlangFool wrote: Sat Sep 26, 2020 3:14 pm
longinvest wrote: Sat Sep 26, 2020 2:20 pm
KlangFool wrote: Sat Sep 26, 2020 12:42 pm
longinvest wrote: Sat Sep 26, 2020 12:26 pm KlangFool, ($300,000 / $1,500,000) = 20%. In the context of my post, this represents a short-term -80% portfolio loss. No further calculation is needed to answer that this is a 100% stocks portfolio. Why are you asking such an obvious question?

longinvest,


My brain is stuck. It is not obvious to me.


My actual AA is 60/40 with a portfolio of 1.5 million. In this case, even if I do not set a FI limit of 300K on my rebalancing, I would never breach the portfolio minimum size of 300K.

Please confirm.

Thanks again.


KlangFool
KlangFool, when people retire, they usually have some (current or future) pension like Social Security (possibly delayed to age 70) or a work pension. Or, when they don't, they can buy an inflation-indexed SPIA*. I usually suggest to look at the overall retirement plan instead of just considering the portfolio in isolation. Our wiki provides a simple-to-use VPW worksheet that implements an adaptive retirement plan. It can be used both during accumulation to help determine reasonable portfolio contribution amounts, and during retirement to determine reasonable portfolio withdrawal amounts. It takes into account the investor's age, salary and target retirement/financial independence age (during accumulation), portfolio size and asset allocation, as well as current and future pensions with and without cost-of-living adjustments. It conveniently informs the user of the immediate impact of a -50% stock loss on the plan. It can be instructive to look at the impact of changing the chosen asset allocation. OK. Let's go back to your question.

* Single premium immediate annuity.

Let's calculate what could happen to a $1,500,000 regularly-rebalanced 60/40 stock/bond portfolio while stocks are gradually losing -80% of their value, a Great Depression like scenario.

Note that the assumption that stocks gradually lose -80% of their value over 200 days with daily rebalancing while bond don't move is mathematically quite pessimistic. In real life, stock losses are uneven and asset prices fluctuate daily, softening cumulative losses when rebalancing. In other words, my calculations, below, are pessimistic.
  • Stocks lose ((1 - 80%)^(1/200) - 1) = -0.8015% each day
  • The 60/40 stock/bond portfolio loses: (60% X -0.8015%) = -0.4809% each day
  • Over 200 days, while stocks are losing -80% of their value, the $1,500,000 portfolio shrinks to ($1,500,000 X ((1 - 0.4809%)^200)) = $571,985
I'll add, for the benefit of readers, that it would be a mistake to compare the above portfolio to a non-rebalanced 60/40 stock/bond portfolio which would drop to (($900,000 - 80%) + $600,000) = $780,000 and have a 23/77 stock/bond allocation after the loss. If the objective is to preserve at least this amount when stocks lose -80%, repeating the calculations of my earlier post tells us that the investor should use a 40/60 stock/bond allocation instead and rebalance it.
  • Stocks lose ((1 - 80%)^(1/200) - 1) = -0.8015% each day
  • The 40/60 stock/bond portfolio loses: (40% X -0.8015%) = -0.3206% each day
  • Over 200 days, the $1,500,000 portfolio shrinks to ($1,500,000 X ((1 - 0.3206%)^200)) = $789,183 and still has a 40% exposure to stocks, which is ((40% / 23%) - 1) = 74% more than the non-rebalanced portfolio now that stocks are dirt cheap
Is this what you were looking for?
longinvest,


Thanks for answering my question.


The net effect for me with an AA of 60/40 and a portfolio of 1.5M is that I would never reach a minimal limit of 300K in FI under your scenario. This is assuming that I rebalance.


KlangFool
If I understand correctly longinvest is assuming you would rebalance daily. Do you do that? Or would you?
"Success is going from failure to failure without loss of enthusiasm." Winston Churchill.
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Re: Never Ever Rebalance Bonds into Stocks?

Post by longinvest »

KlangFool wrote: Sat Sep 26, 2020 3:14 pm The net effect for me with an AA of 60/40 and a portfolio of 1.5M is that I would never reach a minimal limit of 300K in FI under your scenario. This is assuming that I rebalance.
KlangFool, effectively. Stocks would need to gradually lose -93% of their value for the regularly rebalanced 60/40 portfolio to shrink to $305,488. That's like stocks losing another 50% at the bottom of the Great Depression, then losing another 30%. If this ever happens, we'll all have more pressing problems than what's happening to our broadly-diversified index portfolios.
Last edited by longinvest on Sat Sep 26, 2020 3:44 pm, edited 2 times in total.
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Re: Never Ever Rebalance Bonds into Stocks?

Post by Northern Flicker »

Uncorrelated wrote: Drawdown based utility functions are one of those things that sound intuitive but fail in spectacular ways. Here are some examples...
Unless the utility function includes asset size as an input parameter, drawdowns are logically equivalent to rebalances.

If you have a $100K portfolio and rescale it to a $200K portfolio, keeping the same assets and weightings, and use the same asset-size-independent utility function in both cases, then optimizing the utility function to make a decision, will result in the same decision in both cases.

A drawdown is equivalent to a rebalancing decision and rescaling of asset size. I think optimization of a utility function will have the same level of success or failure making drawdown decisions as making rebalancing decisions.
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Re: Never Ever Rebalance Bonds into Stocks?

Post by KlangFool »

longinvest wrote: Sat Sep 26, 2020 3:39 pm
KlangFool wrote: Sat Sep 26, 2020 3:14 pm The net effect for me with an AA of 60/40 and a portfolio of 1.5M is that I would never reach a minimal limit of 300K in FI under your scenario. This is assuming that I rebalance.
KlangFool, effectively. Stocks would need to gradually lose -93% of their value for the regularly rebalanced 60/40 portfolio to shrink to $305,488.

Thanks.


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Re: Never Ever Rebalance Bonds into Stocks?

Post by KlangFool »

rossington wrote: Sat Sep 26, 2020 3:39 pm
KlangFool wrote: Sat Sep 26, 2020 3:14 pm
longinvest wrote: Sat Sep 26, 2020 2:20 pm
KlangFool wrote: Sat Sep 26, 2020 12:42 pm
longinvest wrote: Sat Sep 26, 2020 12:26 pm KlangFool, ($300,000 / $1,500,000) = 20%. In the context of my post, this represents a short-term -80% portfolio loss. No further calculation is needed to answer that this is a 100% stocks portfolio. Why are you asking such an obvious question?

longinvest,


My brain is stuck. It is not obvious to me.


My actual AA is 60/40 with a portfolio of 1.5 million. In this case, even if I do not set a FI limit of 300K on my rebalancing, I would never breach the portfolio minimum size of 300K.

Please confirm.

Thanks again.


KlangFool
KlangFool, when people retire, they usually have some (current or future) pension like Social Security (possibly delayed to age 70) or a work pension. Or, when they don't, they can buy an inflation-indexed SPIA*. I usually suggest to look at the overall retirement plan instead of just considering the portfolio in isolation. Our wiki provides a simple-to-use VPW worksheet that implements an adaptive retirement plan. It can be used both during accumulation to help determine reasonable portfolio contribution amounts, and during retirement to determine reasonable portfolio withdrawal amounts. It takes into account the investor's age, salary and target retirement/financial independence age (during accumulation), portfolio size and asset allocation, as well as current and future pensions with and without cost-of-living adjustments. It conveniently informs the user of the immediate impact of a -50% stock loss on the plan. It can be instructive to look at the impact of changing the chosen asset allocation. OK. Let's go back to your question.

* Single premium immediate annuity.

Let's calculate what could happen to a $1,500,000 regularly-rebalanced 60/40 stock/bond portfolio while stocks are gradually losing -80% of their value, a Great Depression like scenario.

Note that the assumption that stocks gradually lose -80% of their value over 200 days with daily rebalancing while bond don't move is mathematically quite pessimistic. In real life, stock losses are uneven and asset prices fluctuate daily, softening cumulative losses when rebalancing. In other words, my calculations, below, are pessimistic.
  • Stocks lose ((1 - 80%)^(1/200) - 1) = -0.8015% each day
  • The 60/40 stock/bond portfolio loses: (60% X -0.8015%) = -0.4809% each day
  • Over 200 days, while stocks are losing -80% of their value, the $1,500,000 portfolio shrinks to ($1,500,000 X ((1 - 0.4809%)^200)) = $571,985
I'll add, for the benefit of readers, that it would be a mistake to compare the above portfolio to a non-rebalanced 60/40 stock/bond portfolio which would drop to (($900,000 - 80%) + $600,000) = $780,000 and have a 23/77 stock/bond allocation after the loss. If the objective is to preserve at least this amount when stocks lose -80%, repeating the calculations of my earlier post tells us that the investor should use a 40/60 stock/bond allocation instead and rebalance it.
  • Stocks lose ((1 - 80%)^(1/200) - 1) = -0.8015% each day
  • The 40/60 stock/bond portfolio loses: (40% X -0.8015%) = -0.3206% each day
  • Over 200 days, the $1,500,000 portfolio shrinks to ($1,500,000 X ((1 - 0.3206%)^200)) = $789,183 and still has a 40% exposure to stocks, which is ((40% / 23%) - 1) = 74% more than the non-rebalanced portfolio now that stocks are dirt cheap
Is this what you were looking for?
longinvest,


Thanks for answering my question.


The net effect for me with an AA of 60/40 and a portfolio of 1.5M is that I would never reach a minimal limit of 300K in FI under your scenario. This is assuming that I rebalance.


KlangFool
If I understand correctly longinvest is assuming you would rebalance daily. Do you do that? Or would you?

I do both 5/25 and annual rebalancing. To reach somewhat equivalent drop, it would have to be 3 larger than 30% drop over that period.


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Re: Never Ever Rebalance Bonds into Stocks?

Post by billthecat »

HomerJ wrote: Thu Sep 24, 2020 8:10 am
billthecat wrote: Thu Sep 24, 2020 12:11 am
Suppose a 60/40 portfolio is the goal based on risk, resulting in $1.2M in FI, with a personal requirement to maintain at least $1.0M in FI. It seems like your strategy is a combination of the two approaches? If the market tanked, you would withdraw from FI to cover expenses, and might rebalance into equity the excess FI above the $1M minimum?
That's a pretty good characterization of my plan.
And, if your FI declined to $1.0M - due to withdrawals and/or allocation to equity - but the market was still tanked, you would continue to draw from FI, bringing it below $1.0M, because the $1.0M minimum is the minimum during good times so that you could draw from it during extended bad times, right?
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Re: Never Ever Rebalance Bonds into Stocks?

Post by longinvest »

alluringreality wrote: Sat Sep 26, 2020 3:38 pm
longinvest wrote: Sat Sep 26, 2020 10:45 am 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.
Is it necessarily illogical to avoid putting money into a marketable asset if someone is unwilling to accept a decline of that asset? By avoiding moving a portion of assets into a marketable asset, such as the stock market, it simply means that portion of assets does not stand to either gain or decline in value as the market changes. If it makes sense to withdraw appreciated assets or to add additional money into depreciated assets is a somewhat subjective discussion, since what people really care about is the somewhat unknown future. While I generally dislike the tone of the book, the four authors from The 3 Simple Rules of Investing suggest that it's debatable if using a set allocation and rebalancing is necessarily the only logical way of managing risk. Personally I don't think rebalancing makes sense for me, simply because savings bonds appear more in line with my considerations than marketable bonds at this time. Since savings bonds have yearly purchase limits and other terms, they don't really fit well with the idea of using a closely managed allocation and rebalancing.
Alluringreality, here's the quote with more context to better understand it:
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.
There are other uses for bonds and cash instruments than being added to a portfolio of marketable assets to manage its risk. In particular, one could build a non-rolling ladder of Treasury Inflation-Protected Securities (TIPS) such that the annual sum of coupons and maturing principals is relatively constant over the life ot the ladder. In this case, the non-rolling ladder is used as an inflation-indexed term certain annuity. Note that it doesn't replace a life annuity; its role is usually to provide an income bridge until the start of an inflation-indexed life annuity with similar annual payments (like Social Security, possibly delayed until age 70). This is a very specific use of a particular type of bonds, where each security was chosen according to its specific future predetermined inflation-indexed coupon and principal payments.

Another example is the use of a savings account as an "emergency fund", which is a store of immediately available money for young workers who haven't started building a portfolio or for investors who have all of their stock and bond investments locked away into tax-advantaged accounts.

It's unfortunate that the term "fixed income" confuses some investors into thinking that bonds and CDs are "fixed income streams for the life of the investor", as if the investor could simply reinvest the maturing capital of bonds and CDs into new bonds and CDs, spend coupons and interest payments, and live happily ever after. Unfortunately this fails to consider the erosive impact of inflation on the income stream (unless bonds are inflation-indexed, like TIPS), that interest rates fluctuate and the coupon of future bonds bought with matured capital could be lower, and the fact that bonds could have been bought at a premium (most likely for TIPS, these days, which often carry a negative yield to maturity despite paying inflation-indexed coupons) meaning that the face value is smaller than the price initially paid for the bond. Actually, the concept of only spending income, never touching the principal, is a good way to work longer than necessary, oversave, pinch pennies during retirement, and die as the richest person in the graveyard. This isn't attractive to me.

The way I see things, for retirement, is that the retiree should combine two types of income:
  1. Stable lifelong (inflation-indexed) income: Social Security, pension (if any), inflation-indexed SPIA* (if necessary), and (possibly) home-made bridge of stable income for a predetermined number of years until the start of a delayed pension using bonds or cash investments (non-rolling TIPS ladder, non-rolling I-Bonds ladder, non-rolling CD ladder, or high-interest savings account).
  2. Variable income from an investment portfolio of marketable securities (stocks and bonds), where the income fluctuates with the portfolio. This portfolio is typically built using broad total-market index funds or ETFs covering entire asset classes (domestic stocks, international stocks, domestic bonds, international bonds).
* Single premium immediate annuity.

Any bonds or cash instruments used specifically to build a home-made stable income bridge can't be used for anything else without breaking the plan. That part is fixed and inflexible. (I personally prefer to use an investment portfolio along with the calculations of the VPW worksheet to provide bridge income for a delayed pension, instead of implementing a dedicated home-made stable income bridge).

My comments about rebalancing are related to the investment portfolio which consists of all of the investor's stock and bond (and cash) investments, except for any cash or bonds used to build an income bridge for a delayed pension or an emergency fund. The investment portfolio is used to deliver variable income. It also provides liquidity and flexibility to deal with unanticipated life events or plan changes. Reducing its volatility can reduce variable income fluctuations and, more importantly, allow the portfolio to still have sufficient marketable value when unanticipated money needs happen during a stock downturn.

What I explained in the quote (and the original post it was extracted from) was that rebalancing the investment portfolio is the logical thing to do.
Last edited by longinvest on Sun Sep 27, 2020 9:42 am, edited 7 times in total.
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Re: Never Ever Rebalance Bonds into Stocks?

Post by HomerJ »

billthecat wrote: Sat Sep 26, 2020 3:55 pm
HomerJ wrote: Thu Sep 24, 2020 8:10 am
billthecat wrote: Thu Sep 24, 2020 12:11 am
Suppose a 60/40 portfolio is the goal based on risk, resulting in $1.2M in FI, with a personal requirement to maintain at least $1.0M in FI. It seems like your strategy is a combination of the two approaches? If the market tanked, you would withdraw from FI to cover expenses, and might rebalance into equity the excess FI above the $1M minimum?
That's a pretty good characterization of my plan.
And, if your FI declined to $1.0M - due to withdrawals and/or allocation to equity - but the market was still tanked, you would continue to draw from FI, bringing it below $1.0M, because the $1.0M minimum is the minimum during good times so that you could draw from it during extended bad times, right?
Sure... I'm okay spending principal in bonds while waiting for stocks to recover.
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Re: Never Ever Rebalance Bonds into Stocks?

Post by 000 »

I agree with HomerJ.

My rebalancing rule has a floor for how much of my non-stocks I'm willing to sell. Actually, I have a floor for stocks too.

I won't rebalance into oblivion.

No amount of past data mining or economic theorizing changes the simple fact that an asset class can go to zero.
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Re: Never Ever Rebalance Bonds into Stocks?

Post by Dottie57 »

HomerJ wrote: Thu Sep 24, 2020 11:46 am
Uncorrelated wrote: Thu Sep 24, 2020 11:28 amAs I mentioned earlier, it is easy to prove that bucket or one-way rebalance approaches are always suboptimal. You only have to understand bellman's principle of optimality to see why.
Many of us doing it this way do not care about finding the "optimal" approach.

If you've made the decision to retire, you've said "I have enough".

It is NOT necessary at that point to rebalance from bonds to stocks to have "more".

We already have "enough". By definition, "more" is not very important if one already has "enough".

I'm all about preservation in retirement. Don't care about optimization, or increasing my odds of having a larger portfolio.

If stocks go down, I'll live off the bonds until stocks come back. In the long-run, it's very likely stocks will still give me a good return. I don't need to rebalance into stocks to get an even better return.

Because that puts my safe money and my retirement at risk if the Great Depression II happens and stocks DON'T recover for a decade or two. It's happened before. It can happen again.

I don't need to put my retirement at risk, even if the odds are very high that I will get "more" with that strategy. I already have "enough". I don't need "more".
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Re: Never Ever Rebalance Bonds into Stocks?

Post by willthrill81 »

Tattarrattat wrote: Fri Sep 25, 2020 3:51 pm Appreciate the math/economics lessons I agree with those that say that that buckets are basically mental accounting, because it all adds up to a certain AA at any given time, no matter what you call it.
That's demonstrably false IF there is no rebalancing between the buckets. While you can determine the overall AA at any given point in time, a bucket strategy without rebalancing allows for a dynamic AA, one that is not practically replicated by other means.

For instance, if an investor has $1 million in stocks and $1 million in bonds in buckets that will not be rebalanced at the point of retirement, the overall AA is of course 50/50. But if the stocks fall in value by 50%, the new AA will be 33/67; if the buckets were rebalanced, it would still be 50/50. Conversely, if the stocks doubled in value, the new AA would be 67/33 if no rebalancing was permitted. This is very similar to the liability matching portfolio approach that many here use, though I bonds and TIPS are used almost exclusively when that is done, and the portion of the portfolio initially allocated to bonds depends on the investors' expenses and time frame.
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Re: Never Ever Rebalance Bonds into Stocks?

Post by 1210sda »

longinvest wrote: Sat Sep 26, 2020 10:45 am
RadAudit wrote: Fri Sep 25, 2020 6:32 pm (Thank you longinvest viewtopic.php?t=297459)
Thanks 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: It's worth restating the conclusion:
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.
I strongly encourage readers to take the time to read both of these posts.

Rebalancing is part of the 10th principle of the Bogleheads investment philosophy: Stay the course.
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.
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.

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 rebalance 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.
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Re: Never Ever Rebalance Bonds into Stocks?

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Re: Never Ever Rebalance Bonds into Stocks?

Post by longinvest »

000 wrote: Sat Sep 26, 2020 6:53 pm I agree with HomerJ.

My rebalancing rule has a floor for how much of my non-stocks I'm willing to sell. Actually, I have a floor for stocks too.

I won't rebalance into oblivion.

No amount of past data mining or economic theorizing changes the simple fact that an asset class can go to zero.
000, the absolutely safest portfolio, in face of the possibility of a total collapse of entire markets, is a global portfolio of all stocks and bonds rebalanced to market capitalization weights, as suggested by William Sharpe (see The Market Portfolio). Rebalancing to market caps would let the portfolio survive a situation were one of the two major asset classes dropped to zero and restarted, then the second major asset class dropped to zero and restarted. A non-rebalanced portfolio would fail, in such a situation.

Even in a normal (non-catastrophic) situation, a non-rebalanced portfolio remains unattractive as it drifts away from market capitalization and often becomes concentrated into a single asset class over time.

The index funds that Bogleheads use (total U.S./international stock/bond index funds) are softly rebalanced* daily to market capitalization weights with investor cash flows. Occasionally, managers do additional transactions to rebalance them when assets drift too much and investor cash flows are insufficient to fix it. I wouldn't be surprised to learn that most forum members who are against rebalancing their portfolio actually have most of money invested into these funds, and as a result, they're effectively rebalancing (independent parts of) their portfolio daily. Holding funds, instead of individual securities, is actually good for them. Maybe they should consider doing as I do, invest into a global balanced fund and let fund managers take care of portfolio maintenance.

* Price fluctuations don't tigger a need for rebalancing. Rebalancing is only required as a result of changes in the composition of the tracked market, like bond upgrades or downgrades, new stock or bond issues, etc. That's why index funds tend to have a low turnover.

Investing into the Market Portfolio is sensible, but there's some asymmetry in the returns and risks experienced by domestic and foreign investors into the same securities. Foreign investment returns can be affected by currency fluctuations and withholding taxes. Foreign investors are slightly more vulnerable to confiscation risk. etc. I'm of the opinion that Vanguard's LifeStrategy Moderate Growth Fund (VSMGX) is similar enough to Sharpe's Market Portfolio, but with a moderate home bias for U.S. investors. It invests into over 27,000 global securities (see this post). For interested readers, I've estimated its approximate asset and home biases in this post. My wife and I have our entire portfolio invested into a similar Vanguard all-in-one global balanced index ETF, but with a different home bias. It simplifies investing for my wife and it helps me sidestep a long list of potential behavioral pitfalls.
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Re: Never Ever Rebalance Bonds into Stocks?

Post by willthrill81 »

longinvest wrote: Sat Sep 26, 2020 10:45 am The fact that our retiree is considering not to rebalance 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 automatically rebalanced; she'll be able to enjoy her retirement, instead.
It's hard for me to understand why you believe that stocks have higher expected returns when they're cheaper but don't believe that it's prudent for retirees to adjust their withdrawals at all in accordance with that expectation (i.e. the VPW method).
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Re: Never Ever Rebalance Bonds into Stocks?

Post by 000 »

longinvest wrote: Sun Sep 27, 2020 4:03 pm 000, the absolutely safest portfolio, in face of the possibility of a total collapse of entire markets, is a global portfolio of all stocks and bonds rebalanced to market capitalization weights, as suggested by William Sharpe (see The Market Portfolio). Rebalancing to market caps would let the portfolio survive a situation were one of the two major asset classes dropped to zero and restarted, then the second major asset class dropped to zero and restarted. A non-rebalanced portfolio would fail, in such a situation.
longinvest,

The road to zero (or effective zero) is more likely to be characterized by a long, drawn out, and painful series of drops, not a single -100% drop, meaning that rebalancing on those drops is indeed rebalancing to oblivion. When bad events happen, there are always some who hold out hope longer than others that they can reverse the problem, causing the process to be dragged out. One close example is the stock market crash during the Great Depression: there were many drops before the ultimate drawdown of -90% was hit.

Moreover, a major asset class losing substantially all value is typically because it has become completely uninvestable (Russia 1923, China 1945).

The situation where a major asset class goes to effective zero, then restarts, then another major asset class does the same seems exceedingly unlikely to occur. Nevertheless, let's consider the only scenario I can imagine where something like this might be possible: A severe global depression causes massive failure of public corporations (who have more ongoing costs than small local operators), causing global stocks to lose essentially all value. Then the massive bankruptcies cause large scale default on corporate debt and, due to the sudden loss of tax revenue, of sovereign debt too. Unless many new corporations were listed on the stock market during the interim, there was no useful rebalancing to be done.

Finally, I must strongly disagree that the world market portfolio of (publicly traded) stocks and bonds is the absolutely safest portfolio in this or any other context. Due to the highly interconnected and interdependent nature of the global financial and political systems, a crisis in liquid financial assets has a high probability of spreading to nearly all corners of the market. I believe that adding other asset classes such as private businesses, directly owned land, usable goods, and precious metals to the portfolio makes it safer for the kinds of catastrophic risks under discussion here.
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Re: Never Ever Rebalance Bonds into Stocks?

Post by RadAudit »

rossington wrote: Sat Sep 26, 2020 3:39 pm If I understand correctly longinvest is assuming you would rebalance daily. Do you do that? Or would you?
LifeStrategy funds look like they do it. I can't (portfolio restrictions). Probably wouldn't if I could.
longinvest wrote: Sun Sep 27, 2020 4:03 pm The index funds that Bogleheads use (total U.S./international stock/bond index funds) are softly rebalanced* daily to market capitalization weights with investor cash flows. Occasionally, managers do additional transactions to rebalance them when assets drift too much and investor cash flows are insufficient to fix it. ...

* Price fluctuations don't trigger a need for rebalancing. Rebalancing is only required as a result of changes in the composition of the tracked market, like bond upgrades or downgrades, new stock or bond issues, etc. That's why index funds tend to have a low turnover.


And then again, maybe they don't do it as often as it looks.
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Re: Never Ever Rebalance Bonds into Stocks?

Post by longinvest »

RadAudit wrote: Sun Sep 27, 2020 5:14 pm
rossington wrote: Sat Sep 26, 2020 3:39 pm If I understand correctly longinvest is assuming you would rebalance daily. Do you do that? Or would you?
LifeStrategy funds look like they do it. I can't (portfolio restrictions). Probably wouldn't if I could.
longinvest wrote: Sun Sep 27, 2020 4:03 pm The index funds that Bogleheads use (total U.S./international stock/bond index funds) are softly rebalanced* daily to market capitalization weights with investor cash flows. Occasionally, managers do additional transactions to rebalance them when assets drift too much and investor cash flows are insufficient to fix it. ...

* Price fluctuations don't trigger a need for rebalancing. Rebalancing is only required as a result of changes in the composition of the tracked market, like bond upgrades or downgrades, new stock or bond issues, etc. That's why index funds tend to have a low turnover.


And then again, maybe they don't do it as often as it looks.
RadAudit, mutual funds and ETFs can rebalance their holdings with the daily cash-flows of other investors without generating any additional costs, as they have to manage these cash flows anyway. As a bonus, this happens to be quite tax-efficient.

For individual investors, holding a three-fund portfolio for example, it's most practical to gradually rebalance their portfolio with their own regular cash flows*, investing contributions into the asset below target during accumulation, or taking withdrawals from the asset above target during retirement. To control asset drift, it's sufficient, once a year on the investor's birthday, to fully rebalance the portfolio when an asset has drifted too much off target. See the adaptive bands thread for an elegant method to determine an acceptable (annual) drift. Here's table for those who don't like spreadsheets.

* Here's an interesting tool for this: Optimal lazy portfolio rebalancing calculator.
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Re: Never Ever Rebalance Bonds into Stocks?

Post by HomerJ »

longinvest wrote: Sun Sep 27, 2020 4:03 pmthe absolutely safest portfolio, in face of the possibility of a total collapse of entire markets, is a global portfolio of all stocks and bonds rebalanced to market capitalization weights, as suggested by William Sharpe (see The Market Portfolio). Rebalancing to market caps would let the portfolio survive a situation were one of the two major asset classes dropped to zero and restarted, then the second major asset class dropped to zero and restarted. A non-rebalanced portfolio would fail, in such a situation.
No one is talking about total collapse of entire markets.

I am personally talking about stocks going down a good amount, and taking a long time to come back. Which seems like a more reasonable fear to me. A global Great Depression kind of thing. Which has already happened before. And a global portfolio didn't protect you. The Great Depression was world-wide.

Why rebalance (multiple times) into stocks in such a situation?

I'll just live off my bonds (that are not depleted by rebalancing multiple times into stocks during a Great Depression type event), and wait for stocks to come back.

If stocks don't come back, good thing I never rebalanced.
If stocks do come back, I've got plenty of money for European river cruises again. Just back to even is plenty.

So if I don't rebalance into stocks, I have a good outcome either way.

But if I DO rebalance into stocks, and they take a long time to come back, I can see possible outcomes where I become broke.
Even in a normal (non-catastrophic) situation, a non-rebalanced portfolio remains unattractive as it drifts away from market capitalization and often becomes concentrated into a single asset class over time.
Most of us talking about this rebalance the other direction from stocks into bonds. So this is not really a problem. And when stocks are down, we sell bonds which slowly rebalances us as well.
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Re: Never Ever Rebalance Bonds into Stocks?

Post by willthrill81 »

HomerJ wrote: Sun Sep 27, 2020 7:23 pm
longinvest wrote: Sun Sep 27, 2020 4:03 pmthe absolutely safest portfolio, in face of the possibility of a total collapse of entire markets, is a global portfolio of all stocks and bonds rebalanced to market capitalization weights, as suggested by William Sharpe (see The Market Portfolio). Rebalancing to market caps would let the portfolio survive a situation were one of the two major asset classes dropped to zero and restarted, then the second major asset class dropped to zero and restarted. A non-rebalanced portfolio would fail, in such a situation.
No one is talking about total collapse of entire markets.

I am personally talking about stocks going down a good amount, and taking a long time to come back. Which seems like a more reasonable fear to me. A global Great Depression kind of thing. Which has already happened before. And a global portfolio didn't protect you. The Great Depression was world-wide.

Why rebalance (multiple times) into stocks in such a situation?

I'll just live off my bonds (that are not depleted by rebalancing multiple times into stocks during a Great Depression type event), and wait for stocks to come back.

If stocks don't come back, good thing I never rebalanced.
If stocks do come back, I've got plenty of money for European river cruises again. Just back to even is plenty.

So if I don't rebalance into stocks, I have a good outcome either way.

But if I DO rebalance into stocks, and they take a long time to come back, I can see possible outcomes where I become broke.
In the situation you describe, there is asymmetric risk. By not rebalancing with your bond funds, you can be confident that you'll have enough to meet the essentials. But if you rebalanced with those funds, you might lose the essentials. I perfectly understand why you don't want to take that risk, however small it might be, even if it means that you sacrifice upside potential in the process.
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Re: Never Ever Rebalance Bonds into Stocks?

Post by Zardoz »

Interesting topic and discussion. I have also been thinking about this recently, after reading Michael McClung's discussion of withdrawal strategies in "Living Off Your Money."

I just worked through an example, using a hypothetical retiree who is 65, has essential expenses of 30k per year, and will collect social security in excess of that amount in 5 years. The portfolio is 50/50, 150k in bonds and 150k in stocks.

Let's say stocks fall for 10% per year for the first 3 years, then they gain back 20% in year 4 and 20% in year 5, as the retiree is withdrawing 30k yearly from the portfolio. How does this play out using 3 different strategies?

A) Annual withdrawls of 15k from stocks and 15k from bonds, rebalancing yearly to maintain 50/50 allocation.
B) Annual withdrawls of 15k from stocks and 15k from bonds, only rebalance stocks into bonds
C) Annual withdrawls of 30k from bonds, never rebalance either way

These are the results I get (please double check my math if you are interested):
Age 68 (after 3 consecutive years of 10% stock losses)
A) 171,600 left, 50% stocks
B) 173,700 left, 40% stocks
C) 169,400 left, 65% stocks

Age 70 (after 2 consecutive years of 20% stock gains)
A) 144,700 left, 50% stocks
B) 143,200 left, 50% stocks
c) 157,500 left, 100% stocks

Note: I simplified the calculation by ignoring inflation for A and B... for C we would presume the bonds are TIPS so inflation is not an issue.

I was surprised to see that after the intitial 3 years of 10% losses, the portfolios have similar values. It seems that those who followed A), B) or C) would be happy with their choice and presumably sleep well at night. The other interesting thing is how well C) does here when the market rebounds. Yes, the owner of C) is now 100% stocks, but they also have all of their basic liabilities met by Social Security, so maybe they actually could stay the course at 100% (or close to it) for the discretionary portfolio?
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Re: Never Ever Rebalance Bonds into Stocks?

Post by Uncorrelated »

willthrill81 wrote: Sun Sep 27, 2020 7:34 pm
HomerJ wrote: Sun Sep 27, 2020 7:23 pm
longinvest wrote: Sun Sep 27, 2020 4:03 pmthe absolutely safest portfolio, in face of the possibility of a total collapse of entire markets, is a global portfolio of all stocks and bonds rebalanced to market capitalization weights, as suggested by William Sharpe (see The Market Portfolio). Rebalancing to market caps would let the portfolio survive a situation were one of the two major asset classes dropped to zero and restarted, then the second major asset class dropped to zero and restarted. A non-rebalanced portfolio would fail, in such a situation.
No one is talking about total collapse of entire markets.

I am personally talking about stocks going down a good amount, and taking a long time to come back. Which seems like a more reasonable fear to me. A global Great Depression kind of thing. Which has already happened before. And a global portfolio didn't protect you. The Great Depression was world-wide.

Why rebalance (multiple times) into stocks in such a situation?

I'll just live off my bonds (that are not depleted by rebalancing multiple times into stocks during a Great Depression type event), and wait for stocks to come back.

If stocks don't come back, good thing I never rebalanced.
If stocks do come back, I've got plenty of money for European river cruises again. Just back to even is plenty.

So if I don't rebalance into stocks, I have a good outcome either way.

But if I DO rebalance into stocks, and they take a long time to come back, I can see possible outcomes where I become broke.
In the situation you describe, there is asymmetric risk. By not rebalancing with your bond funds, you can be confident that you'll have enough to meet the essentials. But if you rebalanced with those funds, you might lose the essentials. I perfectly understand why you don't want to take that risk, however small it might be, even if it means that you sacrifice upside potential in the process.

This has nothing do do with sacrificing upside potential, nor is it true that you can be confident that you can meet the essentials if you do not rebalance.

Rather, this has everything to do with market timing. If you start with a 50/50 asset allocation, stocks go up 20% and bonds go down 20%, then you end up with 60/40 asset allocation without a change in net worth. If you do not rebalance, this asset allocation can only be rationalized if the investor believes that the expected return of stocks has increased (or risk has decreased). i.e. market timing. Ultimately this all ties in back to bellman's principle of optimality.

To make matters worse, safety-first strategies have one of the worst metrics of all strategies tested by McClung (as measured by survival probability for a given withdrawal rate):
Image
http://livingoffyourmoney.com/

The "rational" strategy implements a liability matched bond portfolio and the rest in stocks, which appears to be most relevant here. It might also be worth looking at the bonds-first strategy. This strategy is a non-rebalancing strategy, however it depletes the bonds first, which is exactly the opposite of what is usually advertised on this forum. The author has not tested a non-rebalancing bond-bucket strategy because other literature claims the stock-bucket strategy is superior.

(Although I'm linking to McClungs book, I should point out that all the tested strategies fail bellman's principle and therefore should never be used. My optimal strategy, which you also shouldn't use, significantly outperforms all strategies in McClung's book).
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Re: Never Ever Rebalance Bonds into Stocks?

Post by rossington »

longinvest wrote: Sun Sep 27, 2020 5:43 pm
RadAudit wrote: Sun Sep 27, 2020 5:14 pm
rossington wrote: Sat Sep 26, 2020 3:39 pm If I understand correctly longinvest is assuming you would rebalance daily. Do you do that? Or would you?
LifeStrategy funds look like they do it. I can't (portfolio restrictions). Probably wouldn't if I could.
longinvest wrote: Sun Sep 27, 2020 4:03 pm The index funds that Bogleheads use (total U.S./international stock/bond index funds) are softly rebalanced* daily to market capitalization weights with investor cash flows. Occasionally, managers do additional transactions to rebalance them when assets drift too much and investor cash flows are insufficient to fix it. ...

* Price fluctuations don't trigger a need for rebalancing. Rebalancing is only required as a result of changes in the composition of the tracked market, like bond upgrades or downgrades, new stock or bond issues, etc. That's why index funds tend to have a low turnover.


And then again, maybe they don't do it as often as it looks.
RadAudit, mutual funds and ETFs can rebalance their holdings with the daily cash-flows of other investors without generating any additional costs, as they have to manage these cash flows anyway. As a bonus, this happens to be quite tax-efficient.

For individual investors, holding a three-fund portfolio for example, it's most practical to gradually rebalance their portfolio with their own regular cash flows*, investing contributions into the asset below target during accumulation, or taking withdrawals from the asset above target during retirement. To control asset drift, it's sufficient, once a year on the investor's birthday, to fully rebalance the portfolio when an asset has drifted too much off target. See the adaptive bands thread for an elegant method to determine an acceptable (annual) drift. Here's table for those who don't like spreadsheets.

* Here's an interesting tool for this: Optimal lazy portfolio rebalancing calculator.
But in your answer to klangfool above regarding your example of a market decline of 80% after 200 days wasn't the optimal result calculated dependent on rebalancing from bonds to stocks daily in a 60/40 portfolio?. Were you referring to a VTSAX/VBTLX investor that would have to do it on their own.... or a Balanced Fund investor that can rely on the fund to automatically do this for them over the stated period?
Please clarify since both situations exist.
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Re: Never Ever Rebalance Bonds into Stocks?

Post by rossington »

willthrill81 wrote: Sun Sep 27, 2020 7:34 pm
HomerJ wrote: Sun Sep 27, 2020 7:23 pm
longinvest wrote: Sun Sep 27, 2020 4:03 pmthe absolutely safest portfolio, in face of the possibility of a total collapse of entire markets, is a global portfolio of all stocks and bonds rebalanced to market capitalization weights, as suggested by William Sharpe (see The Market Portfolio). Rebalancing to market caps would let the portfolio survive a situation were one of the two major asset classes dropped to zero and restarted, then the second major asset class dropped to zero and restarted. A non-rebalanced portfolio would fail, in such a situation.
No one is talking about total collapse of entire markets.

I am personally talking about stocks going down a good amount, and taking a long time to come back. Which seems like a more reasonable fear to me. A global Great Depression kind of thing. Which has already happened before. And a global portfolio didn't protect you. The Great Depression was world-wide.

Why rebalance (multiple times) into stocks in such a situation?

I'll just live off my bonds (that are not depleted by rebalancing multiple times into stocks during a Great Depression type event), and wait for stocks to come back.

If stocks don't come back, good thing I never rebalanced.
If stocks do come back, I've got plenty of money for European river cruises again. Just back to even is plenty.

So if I don't rebalance into stocks, I have a good outcome either way.

But if I DO rebalance into stocks, and they take a long time to come back, I can see possible outcomes where I become broke.
In the situation you describe, there is asymmetric risk. By not rebalancing with your bond funds, you can be confident that you'll have enough to meet the essentials. But if you rebalanced with those funds, you might lose the essentials. I perfectly understand why you don't want to take that risk, however small it might be, even if it means that you sacrifice upside potential in the process.
Yes, when rebalancing one needs a "floor" if in a severe prolonged stock market decline that provides an essential cushion depending on the investor's risk tolerance and more importantly leaving them with the financial resources they need to survive on if necessary. One should never rebalance into oblivion, there must be a limit.
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Re: Never Ever Rebalance Bonds into Stocks?

Post by Uncorrelated »

rossington wrote: Mon Sep 28, 2020 4:54 am
Yes, when rebalancing one needs a "floor" if in a severe prolonged stock market decline that provides an essential cushion depending on the investor's risk tolerance and more importantly leaving them with the financial resources they need to survive on if necessary. One should never rebalance into oblivion, there must be a limit.
As pointed out by McClung, Bellman's principle of optimality, my optimal asset allocation and several other sources, not "rebalancing into oblivion" unambiguously increases the probability of a failed retirement.

It sounds as if investors have an irrational fear of "rebalancing into oblivion", so much that they are willing to dramatically increase other risks just to protect against a single low-probability event. Ultimately, this can only increase the probability of running out of money.
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Re: Never Ever Rebalance Bonds into Stocks?

Post by KlangFool »

Uncorrelated wrote: Mon Sep 28, 2020 5:41 am
rossington wrote: Mon Sep 28, 2020 4:54 am
Yes, when rebalancing one needs a "floor" if in a severe prolonged stock market decline that provides an essential cushion depending on the investor's risk tolerance and more importantly leaving them with the financial resources they need to survive on if necessary. One should never rebalance into oblivion, there must be a limit.
As pointed out by McClung, Bellman's principle of optimality, my optimal asset allocation and several other sources, not "rebalancing into oblivion" unambiguously increases the probability of a failed retirement.

It sounds as if investors have an irrational fear of "rebalancing into oblivion", so much that they are willing to dramatically increase other risks just to protect against a single low-probability event. Ultimately, this can only increase the probability of running out of money.
Uncorrelated,


This does not help me to understand your point. I need an example with a real set of numbers.

Let's take me as an examples.


A) 2 years of emergency fund.


B) Portfolio of 1.5 million with an AA of 60/40.


C) I use 5/25 and annual rebalancing.

D) My floor is 5 years of FI when I stop rebalancing from the bond to the stock.


E) I can reach 62 years and withdraw Social Security. 2 years of EF plus 5 years of FI get me there.


F) If I delay until 67 years old, Social Security can provide 30K per year to me.


G) My annual expense is 60K.


H) I do not need to worry about a downturn lasting more than 5 years. It is no longer a money problem.


Show me how you can use all those theories to create a better AA for me.


Thanks.


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Re: Never Ever Rebalance Bonds into Stocks?

Post by Uncorrelated »

KlangFool wrote: Mon Sep 28, 2020 7:30 am
Uncorrelated wrote: Mon Sep 28, 2020 5:41 am
rossington wrote: Mon Sep 28, 2020 4:54 am
Yes, when rebalancing one needs a "floor" if in a severe prolonged stock market decline that provides an essential cushion depending on the investor's risk tolerance and more importantly leaving them with the financial resources they need to survive on if necessary. One should never rebalance into oblivion, there must be a limit.
As pointed out by McClung, Bellman's principle of optimality, my optimal asset allocation and several other sources, not "rebalancing into oblivion" unambiguously increases the probability of a failed retirement.

It sounds as if investors have an irrational fear of "rebalancing into oblivion", so much that they are willing to dramatically increase other risks just to protect against a single low-probability event. Ultimately, this can only increase the probability of running out of money.
Show me how you can use all those theories to create a better AA for me.
How do you define better. If I show you an asset allocation with a lower probability of running out of money over a 30 year horizon, would you agree that that asset allocation is "better"?
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Re: Never Ever Rebalance Bonds into Stocks?

Post by KlangFool »

Uncorrelated wrote: Mon Sep 28, 2020 8:00 am
KlangFool wrote: Mon Sep 28, 2020 7:30 am
Uncorrelated wrote: Mon Sep 28, 2020 5:41 am
rossington wrote: Mon Sep 28, 2020 4:54 am
Yes, when rebalancing one needs a "floor" if in a severe prolonged stock market decline that provides an essential cushion depending on the investor's risk tolerance and more importantly leaving them with the financial resources they need to survive on if necessary. One should never rebalance into oblivion, there must be a limit.
As pointed out by McClung, Bellman's principle of optimality, my optimal asset allocation and several other sources, not "rebalancing into oblivion" unambiguously increases the probability of a failed retirement.

It sounds as if investors have an irrational fear of "rebalancing into oblivion", so much that they are willing to dramatically increase other risks just to protect against a single low-probability event. Ultimately, this can only increase the probability of running out of money.
Show me how you can use all those theories to create a better AA for me.
How do you define better. If I show you an asset allocation with a lower probability of running out of money over a 30 year horizon, would you agree that that asset allocation is "better"?

No. Because in my case, I need the ZERO probability of running out of money in 5 years. A near ZERO probability of running out of money in 7 years.


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Re: Never Ever Rebalance Bonds into Stocks?

Post by Leesbro63 »

Another reason to avoid rebalancing is taxes. It seems like much of the conversation here assumes most of one's nest egg is in retirement accounts. What about large taxable portfolios? There's both the tax due upon rebalancing AND the problem of taxflation of a liability-matching-portfolio using TIPS. So I'm back to my original conclusion that for those with large (over $5M, say) taxable portfolios, rebalancing isn't practical and is risky. (Yes, rebalancing into oblivious is a very small possibility scenario but it's also a huge consequence scenario).
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Re: Never Ever Rebalance Bonds into Stocks?

Post by Uncorrelated »

KlangFool wrote: Mon Sep 28, 2020 8:02 am
Uncorrelated wrote: Mon Sep 28, 2020 8:00 am
KlangFool wrote: Mon Sep 28, 2020 7:30 am
Uncorrelated wrote: Mon Sep 28, 2020 5:41 am
rossington wrote: Mon Sep 28, 2020 4:54 am
Yes, when rebalancing one needs a "floor" if in a severe prolonged stock market decline that provides an essential cushion depending on the investor's risk tolerance and more importantly leaving them with the financial resources they need to survive on if necessary. One should never rebalance into oblivion, there must be a limit.
As pointed out by McClung, Bellman's principle of optimality, my optimal asset allocation and several other sources, not "rebalancing into oblivion" unambiguously increases the probability of a failed retirement.

It sounds as if investors have an irrational fear of "rebalancing into oblivion", so much that they are willing to dramatically increase other risks just to protect against a single low-probability event. Ultimately, this can only increase the probability of running out of money.
Show me how you can use all those theories to create a better AA for me.
How do you define better. If I show you an asset allocation with a lower probability of running out of money over a 30 year horizon, would you agree that that asset allocation is "better"?

No. Because in my case, I need the ZERO probability of running out of money in 5 years. A near ZERO probability of running out of money in 7 years.


KlangFool
No strategy offers a 0% change of running out of money.

I'm sorry but I'm unable to provide you with a better strategy unless you are able to describe what you mean by "better". The only thing I can do at this point is prove that your strategy is suboptimal, this follows directly from bellman's principle of optimality.
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Re: Never Ever Rebalance Bonds into Stocks?

Post by KlangFool »

Leesbro63 wrote: Mon Sep 28, 2020 8:23 am Another reason to avoid rebalancing is taxes. It seems like much of the conversation here assumes most of one's nest egg is in retirement accounts. What about large taxable portfolios? There's both the tax due upon rebalancing AND the problem of taxflation of a liability-matching-portfolio using TIPS. So I'm back to my original conclusion that for those with large (over $5M, say) taxable portfolios, rebalancing isn't practical and is risky. (Yes, rebalancing into oblivious is a very small possibility scenario but it's also a huge consequence scenario).
Leesbro63,


I disagreed. My portfolio is 45% taxable, 45% Tax-deferred, and 10% Roth. In the case of rebalancing when the stock market is down, you could TLH and eliminate the tax liability of the rebalancing.


I have 500K in my taxable account.


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Re: Never Ever Rebalance Bonds into Stocks?

Post by Leesbro63 »

KlangFool wrote: Mon Sep 28, 2020 8:45 am
Leesbro63 wrote: Mon Sep 28, 2020 8:23 am Another reason to avoid rebalancing is taxes. It seems like much of the conversation here assumes most of one's nest egg is in retirement accounts. What about large taxable portfolios? There's both the tax due upon rebalancing AND the problem of taxflation of a liability-matching-portfolio using TIPS. So I'm back to my original conclusion that for those with large (over $5M, say) taxable portfolios, rebalancing isn't practical and is risky. (Yes, rebalancing into oblivious is a very small possibility scenario but it's also a huge consequence scenario).
Leesbro63,


I disagreed. My portfolio is 45% taxable, 45% Tax-deferred, and 10% Roth. In the case of rebalancing when the stock market is down, you could TLH and eliminate the tax liability of the rebalancing.


I have 500K in my taxable account.


KlangFool
Doesn’t work as well for taxable accounts over, say, $5M
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Re: Never Ever Rebalance Bonds into Stocks?

Post by willthrill81 »

Uncorrelated wrote: Mon Sep 28, 2020 3:02 am
willthrill81 wrote: Sun Sep 27, 2020 7:34 pm
HomerJ wrote: Sun Sep 27, 2020 7:23 pm
longinvest wrote: Sun Sep 27, 2020 4:03 pmthe absolutely safest portfolio, in face of the possibility of a total collapse of entire markets, is a global portfolio of all stocks and bonds rebalanced to market capitalization weights, as suggested by William Sharpe (see The Market Portfolio). Rebalancing to market caps would let the portfolio survive a situation were one of the two major asset classes dropped to zero and restarted, then the second major asset class dropped to zero and restarted. A non-rebalanced portfolio would fail, in such a situation.
No one is talking about total collapse of entire markets.

I am personally talking about stocks going down a good amount, and taking a long time to come back. Which seems like a more reasonable fear to me. A global Great Depression kind of thing. Which has already happened before. And a global portfolio didn't protect you. The Great Depression was world-wide.

Why rebalance (multiple times) into stocks in such a situation?

I'll just live off my bonds (that are not depleted by rebalancing multiple times into stocks during a Great Depression type event), and wait for stocks to come back.

If stocks don't come back, good thing I never rebalanced.
If stocks do come back, I've got plenty of money for European river cruises again. Just back to even is plenty.

So if I don't rebalance into stocks, I have a good outcome either way.

But if I DO rebalance into stocks, and they take a long time to come back, I can see possible outcomes where I become broke.
In the situation you describe, there is asymmetric risk. By not rebalancing with your bond funds, you can be confident that you'll have enough to meet the essentials. But if you rebalanced with those funds, you might lose the essentials. I perfectly understand why you don't want to take that risk, however small it might be, even if it means that you sacrifice upside potential in the process.

This has nothing do do with sacrificing upside potential, nor is it true that you can be confident that you can meet the essentials if you do not rebalance.

Rather, this has everything to do with market timing. If you start with a 50/50 asset allocation, stocks go up 20% and bonds go down 20%, then you end up with 60/40 asset allocation without a change in net worth. If you do not rebalance, this asset allocation can only be rationalized if the investor believes that the expected return of stocks has increased (or risk has decreased). i.e. market timing. Ultimately this all ties in back to bellman's principle of optimality.

To make matters worse, safety-first strategies have one of the worst metrics of all strategies tested by McClung (as measured by survival probability for a given withdrawal rate):
Image
http://livingoffyourmoney.com/

The "rational" strategy implements a liability matched bond portfolio and the rest in stocks, which appears to be most relevant here. It might also be worth looking at the bonds-first strategy. This strategy is a non-rebalancing strategy, however it depletes the bonds first, which is exactly the opposite of what is usually advertised on this forum. The author has not tested a non-rebalancing bond-bucket strategy because other literature claims the stock-bucket strategy is superior.

(Although I'm linking to McClungs book, I should point out that all the tested strategies fail bellman's principle and therefore should never be used. My optimal strategy, which you also shouldn't use, significantly outperforms all strategies in McClung's book).
What HomerJ and others are referring to is basically a form of liability matching. I don't know why you do not see that.
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Re: Never Ever Rebalance Bonds into Stocks?

Post by KlangFool »

Uncorrelated wrote: Mon Sep 28, 2020 8:42 am
KlangFool wrote: Mon Sep 28, 2020 8:02 am
Uncorrelated wrote: Mon Sep 28, 2020 8:00 am
KlangFool wrote: Mon Sep 28, 2020 7:30 am
Uncorrelated wrote: Mon Sep 28, 2020 5:41 am

As pointed out by McClung, Bellman's principle of optimality, my optimal asset allocation and several other sources, not "rebalancing into oblivion" unambiguously increases the probability of a failed retirement.

It sounds as if investors have an irrational fear of "rebalancing into oblivion", so much that they are willing to dramatically increase other risks just to protect against a single low-probability event. Ultimately, this can only increase the probability of running out of money.
Show me how you can use all those theories to create a better AA for me.
How do you define better. If I show you an asset allocation with a lower probability of running out of money over a 30 year horizon, would you agree that that asset allocation is "better"?

No. Because in my case, I need the ZERO probability of running out of money in 5 years. A near ZERO probability of running out of money in 7 years.


KlangFool
No strategy offers a 0% change of running out of money.

I'm sorry but I'm unable to provide you with a better strategy unless you are able to describe what you mean by "better". The only thing I can do at this point is prove that your strategy is suboptimal, this follows directly from bellman's principle of optimality.
Uncorrelated,

Better means that it meets

A) Lowest probability of running out of money in 5 years.

and

B) Lower probability of running out of money in 7 years.


than my current AA and EF. And, deliver even lower probability and/or greater return.

<<The only thing I can do at this point is prove that your strategy is suboptimal, this follows directly from bellman's principle>>

Then, this proves nothing. The solution has to be based on my goals.


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Re: Never Ever Rebalance Bonds into Stocks?

Post by KlangFool »

Leesbro63 wrote: Mon Sep 28, 2020 8:46 am
KlangFool wrote: Mon Sep 28, 2020 8:45 am
Leesbro63 wrote: Mon Sep 28, 2020 8:23 am Another reason to avoid rebalancing is taxes. It seems like much of the conversation here assumes most of one's nest egg is in retirement accounts. What about large taxable portfolios? There's both the tax due upon rebalancing AND the problem of taxflation of a liability-matching-portfolio using TIPS. So I'm back to my original conclusion that for those with large (over $5M, say) taxable portfolios, rebalancing isn't practical and is risky. (Yes, rebalancing into oblivious is a very small possibility scenario but it's also a huge consequence scenario).
Leesbro63,


I disagreed. My portfolio is 45% taxable, 45% Tax-deferred, and 10% Roth. In the case of rebalancing when the stock market is down, you could TLH and eliminate the tax liability of the rebalancing.


I have 500K in my taxable account.


KlangFool
Doesn’t work as well for taxable accounts over, say, $5M

Leesbro63,

It depends on whether you can TLH or not. With a big enough downturn, there is always opportunity for TLH.


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Leesbro63
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Re: Never Ever Rebalance Bonds into Stocks?

Post by Leesbro63 »

KlangFool wrote: Mon Sep 28, 2020 8:52 am
Leesbro63 wrote: Mon Sep 28, 2020 8:46 am
KlangFool wrote: Mon Sep 28, 2020 8:45 am
Leesbro63 wrote: Mon Sep 28, 2020 8:23 am Another reason to avoid rebalancing is taxes. It seems like much of the conversation here assumes most of one's nest egg is in retirement accounts. What about large taxable portfolios? There's both the tax due upon rebalancing AND the problem of taxflation of a liability-matching-portfolio using TIPS. So I'm back to my original conclusion that for those with large (over $5M, say) taxable portfolios, rebalancing isn't practical and is risky. (Yes, rebalancing into oblivious is a very small possibility scenario but it's also a huge consequence scenario).
Leesbro63,


I disagreed. My portfolio is 45% taxable, 45% Tax-deferred, and 10% Roth. In the case of rebalancing when the stock market is down, you could TLH and eliminate the tax liability of the rebalancing.


I have 500K in my taxable account.


KlangFool
Doesn’t work as well for taxable accounts over, say, $5M

Leesbro63,

It depends on whether you can TLH or not. With a big enough downturn, there is always opportunity for TLH.


KlangFool
For those who TLH’d in 2009, let’s hope there’s no further opportunity.
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Uncorrelated
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Re: Never Ever Rebalance Bonds into Stocks?

Post by Uncorrelated »

willthrill81 wrote: Mon Sep 28, 2020 8:50 am What HomerJ and others are referring to is basically a form of liability matching. I don't know why you do not see that.
I see that. The strategy "rational" from McClung is basically liability matching. According to McClung, that strategy is one of the worst performers in terms of SWR, survival probability and related metrics.
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Re: Never Ever Rebalance Bonds into Stocks?

Post by HomerJ »

Uncorrelated wrote: Mon Sep 28, 2020 3:02 amRather, this has everything to do with market timing. If you start with a 50/50 asset allocation, stocks go up 20% and bonds go down 20%, then you end up with 60/40 asset allocation without a change in net worth. If you do not rebalance, this asset allocation can only be rationalized if the investor believes that the expected return of stocks has increased (or risk has decreased). i.e. market timing. Ultimately this all ties in back to bellman's principle of optimality.
This is the exact opposite of what I said.

If stocks go UP 20%, and bonds go down 20% (how often do bonds go down 20%?), I would rebalance FROM stocks to bonds.

It's the other direction that I avoid.

50/50 - Stocks go up 20%, bonds stay flat, I'm now at 55/45... I rebalance back to 50/50.

50/50 - Stocks go down 20%, bonds stay flat, I'm now at 45/55... I don't rebalance, but I withdraw all money from bonds for that year, which rebalances me a little. If, at some point, I'm back to 50/50 again, I start pulling from both stocks and bonds again.

And if stocks recover and move above bonds, I'll go back to rebalancing the other way back to 50/50.

There is no calculation of expected returns EVER. Completely unnecessary.

This system is very easy...

Get dividends from stocks and bonds (probably around 1.5% these days), then sell from whichever side is doing better to get your money for the year.
If stocks are doing a lot better than bonds, you'll sell 100% from the stock side, and rebalance back to 50/50.
If stocks are doing a lot worse than bonds, you'll sell 100% from the bond side, and don't do anything else.
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Re: Never Ever Rebalance Bonds into Stocks?

Post by Steve Reading »

HomerJ wrote: Mon Sep 28, 2020 9:20 am
Uncorrelated wrote: Mon Sep 28, 2020 3:02 amRather, this has everything to do with market timing. If you start with a 50/50 asset allocation, stocks go up 20% and bonds go down 20%, then you end up with 60/40 asset allocation without a change in net worth. If you do not rebalance, this asset allocation can only be rationalized if the investor believes that the expected return of stocks has increased (or risk has decreased). i.e. market timing. Ultimately this all ties in back to bellman's principle of optimality.
This is the exact opposite of what I said.

If stocks go UP 20%, and bonds go down 20% (how often do bonds go down 20%?), I would rebalance FROM stocks to bonds.

It's the other direction that I avoid.

50/50 - Stocks go up 20%, bonds stay flat, I'm now at 55/45... I rebalance back to 50/50.

50/50 - Stocks go down 20%, bonds stay flat, I'm now at 45/55... I don't rebalance, but I withdraw all money from bonds for that year, which rebalances me a little.
This is the part where you're market timing because you have as much money as you used to have at 50/50, but are choosing to be 45/55 with that sum now. Why were you OK with having, say, $1M at 50/50 and now that same $1M only at 45/55? The only thing that has happened is that stocks have dropped, nothing else has changed in your financial circumstances. Changing an asset allocation based on past stock performance is the epitome of market timing.

The idea of "I don't want to rebalance into oblivion" and an LMP maybe has merit only if you change your allocation as a function of wealth. So if you had $1M, stocks drop 20%, bonds don't do anything and you choose to not rebalance. Here, you MIGHT make the argument that "I am ok letting my allocation become 44/56 because I have less money and hence, I want to be more conservative".

While I think the idea of "rebalancing into oblivion" is grossly overblown in this thread, if you follow it in terms of "my asset allocation will be X as a function of my wealth", then the strategy once again becomes path independent and at least clears the Bellman hurdle. And it still protects against your "rebalancing into oblivion".

But the issue is you've extrapolated it into "not rebalancing into stocks EVER" which introduces market timing in situations like what Uncorrelated described.
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Re: Never Ever Rebalance Bonds into Stocks?

Post by Uncorrelated »

KlangFool wrote: Mon Sep 28, 2020 8:50 am <<The only thing I can do at this point is prove that your strategy is suboptimal, this follows directly from bellman's principle>>

Then, this proves nothing. The solution has to be based on my goals.
Bellman's principle of optimality shows that there is an equivalence relation between "strategy is suboptimal" and "path dependence". The observation that your strategy contains path-dependent aspects is sufficient to prove it's not optimal for any goal. I think this is the 5th time that I had to repeat this, it's starting to get a little old.



Here is a trivial strategy that is better than your current strategy:
  1. Follow the same strategy as before in years 1-6.
  2. Recall that in the 7th year and last year, the required spending is 60k. In the last year just before you make your withdrawal for the year, if your net worth is below 60k, go to a casino and bet everything on black. Repeat until you are either bankrupt or your net worth is above 60k.
As per 1), this strategy has the same probability of running out of money in the first 6 years. As per 2), if the original strategy succeeded, then my adjusted strategy also succeeds. Also as per 2) in some cases where the original strategy fails, the adjusted strategy succeeds. Therefore, this strategy has a higher probability of succeeding than the original strategy. That was easy.


Slightly less joking, the strategy on this figure (source) has the lowest probability of running out of money for any number of years, assuming constant spending and modeling assumptions detailed in the source link. The color scale indicates the percentage allocation to stocks, contour lines indicate probability of success. The figure shows that as your net worth decreases, the stock allocation should be increased. This is exactly the opposite of what your strategy does.
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Re: Never Ever Rebalance Bonds into Stocks?

Post by HomerJ »

Uncorrelated wrote: Mon Sep 28, 2020 8:57 am
willthrill81 wrote: Mon Sep 28, 2020 8:50 am What HomerJ and others are referring to is basically a form of liability matching. I don't know why you do not see that.
I see that. The strategy "rational" from McClung is basically liability matching. According to McClung, that strategy is one of the worst performers in terms of SWR, survival probability and related metrics.
The error in both McClung and your calculations is probably because you both assume constant spending no matter what.

Also, of course, you both seem to ignore the human emotional element.

Look, if the stock market crashes, and comes back, which I agree is extremely likely (99%?), I'll be fine without rebalancing into stocks. Why do I need to rebalance into stocks to increase my returns? Just normal returns from a buy and hold complement of stocks has been pretty solid in the past.

A large complement of bonds protects me from a bad sequence of returns in stocks.

If stocks go up, great I sell stocks for living expenses, and even rebalance if they go up a lot.
If stocks go down, I sell bonds for living expenses, and wait for stocks to come back. Maybe cut back spending if they stay down for an extended period.

I don't need to rebalance into stocks. If they come back like normal, I'm still fine. If they don't come back, I'm also fine because I didn't throw all my bond money into stocks. I am more protected this way.

I've been explaining my method over and over.

All you've done is said I'm wrong. Show a better way, with numbers and examples, please.
A Goldman Sachs associate provided a variety of detailed explanations, but then offered a caveat, “If I’m being dead-### honest, though, nobody knows what’s really going on.”
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