Rebalancing theory

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richard
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Rebalancing theory

Post by richard » Wed May 30, 2012 7:38 am

Conventional wisdom on this board is to have a set asset allocation and to periodically rebalance to that allocation. The typical reason is to maintain a constant level of risk (some say it gets the benefit of a "rebalancing bonus" which is another topic).

The constant level of risk argument implicitly assumes that stocks and bonds have constant risk levels, or at least constant relative risk levels. I can't find any good theoretical basis for this view. The main support I find is that rebalancing to fixed percentages is easy.

I just saw an interview with William Sharpe that includes his take on this infrequently discussed subject:
The argument against a constant mix strategy is that if, for example, you set a target of 60% equities and 40% bonds, and the prices of equities rise (and the prices of bonds don’t), then you have to sell stocks and buy bonds. If everyone had a constant mix strategy they would all try to follow that pattern, and there would be a lack of buyers and sellers on the other side of the trades. Not everyone can follow that strategy, and sell what has risen while buying what has fallen. Thus it involves betting against the market. The same argument also applies to target date and life cycle funds. If the market moves sharply, they will have to sell the relative winner and buy the relative loser.

I believe there is a better way. If you are an average investor, invest in market average proportions, and live with the changes in the markets. If you are affected more by changes in wealth than the average investor you may want to decrease your stock position after stocks outpace bonds, and do some rebalancing, trading with someone who should be rebalancing in the other direction. More generally, you should always look at the market value of securities. Market values reflect a consensus of opinions regarding value. Without a sense of the value of asset classes you are throwing away critical pieces of information. At Financial Engines we look at the values of major asset classes every single month and incorporate this information when we analyze investor portfolios. The result is that we don’t advocate a lot of trading. This kind of a coherent system leads to advice and management that is closer to a buy and hold behavior than a constant mix strategy.

Of course bonds have maturities and calls, new shares are issued by corporations and companies sometimes buy back shares. Over the longer run these actions tend to cause market proportions to come back to something like a 60/40 stock/bond mix. The message is that investors should not be slavishly rebalancing over time. There is a better way, which is to invest taking into account current market values. This will also save a lot in transaction costs.
http://www.stanford.edu/~wfsharpe/art/apinterview.pdf (thanks fundtalker123 for posting the link).

This is not to say don't rebalance. Rather it's saying rebalance based on market proportion changes (which often means doing nothing), not constant percentages.

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Re: Rebalaning theory

Post by tetractys » Wed May 30, 2012 11:07 am

So then how exactly would someone do this?

My understanding is that most of the value evaluation is taken care of by the market itself when rebalancing to a constant asset allocation. And trying to evaluate valuations is iffy, and could randomly backfire or help, becoming more or less a wash. -- Tet

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Re: Rebalaning theory

Post by yobria » Wed May 30, 2012 11:25 am

Yes, rebalancing to a target risk level is easy. That doesn't mean making things harder, eg considering the "market value of securities", will conjure up a free lunch. I find folks who advise against keeping things simple usually have a product to sell.

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Re: Rebalaning theory

Post by Muchtolearn » Wed May 30, 2012 11:27 am

His statement started well and then went downhill. It made sense to me that you invest per your AA and then leave it alone. Once he gets to investing in "market proportions", there are a few things that strike me. How would any of us know what market proportions are? That's crazy. Second, I guess he is saying that Financial Engines knows and therefore maybe it is just a marketing ploy :confused

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Re: Rebalaning theory

Post by Call_Me_Op » Wed May 30, 2012 11:41 am

Keep it simple.
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Re: Rebalancing theory

Post by bobcat2 » Wed May 30, 2012 11:56 am

The concept of rebalancing a portfolio does not come from personal finance common sense wisdom. It comes instead from a paper on the life-cycle model of personal finance written by Robert Merton around 1970. One of the things that fell out of Merton's optimal control solution to his life-cycle model was that the household's portfolio of financial assets should be continuously rebalanced to keep the portfolio on target to meet its financial goals. In the usual case of a portfolio primarily for retirement this means rebalancing the portfolio frequently to keep the portfolio on target to meet its retirement income goals - both floor and aspirational.

Since financial practitioners didn't and don't know how to rebalance a portfolio to meet income goals (or for that matter even have income goals), they settled instead on the simplistic strategy of rebalancing assets to a set AA, or a predetermined schedule of asset allocations over time.

Sharpe is suggesting that institutional investors, not individual investors, would be better served by rebalancing to market proportions rather than set asset allocations. I believe Sharpe would agree that Merton's method is the best way for individuals to rebalance their portfolios. You have a finite amount of time to reach fairly specific retirement goals in your personal portfolio. Institutional investors OTOH often have for practical purposes near infinite time horizons and often less specific goals. Think Yale endowment.

BTW the Dimensional DC Managed Retirement plan rebalances the participant's portfolio monthly in a manner consistent with Merton's paper. There is no surprise here, since Merton designed the Dimensional DC Managed retirement plan.

There is no justification in financial theory for rebalancing to a set AA. Sometimes it helps; sometimes it makes little difference; and sometimes it makes things worse. However, if someone is getting paid to manage your portfolio it may seem that he is doing something important to help justify his fee when he rebalances your portfolio. :wink:

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Last edited by bobcat2 on Wed May 30, 2012 12:02 pm, edited 2 times in total.
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Re: Rebalaning theory

Post by Dave_HWW » Wed May 30, 2012 12:00 pm

tetractys wrote:So then how exactly would someone do this?
Muchtolearn wrote:His statement started well and then went downhill. It made sense to me that you invest per your AA and then leave it alone. Once he gets to investing in "market proportions", there are a few things that strike me. How would any of us know what market proportions are? That's crazy. Second, I guess he is saying that Financial Engines knows and therefore maybe it is just a marketing ploy :confused
You guys are making this more complicated than it is. After selecting an initial risk profile:
-Someone would do this by doing nothing (ie not trading) except to reinvest dividends.
-"Market proportions" are simply whatever the unrebalanced portfolio is without reinvested dividends (so if the initial risk profile is average then that would be cap-weights...otherwise it's simply whatever the weights of the unrebalanced portfolio are).

So Sharp is simply saying that the overall portfolio should be managed just like any other cap-weighted index fund (instead of using a contrarian trading strategy to rebalance like an equal weighted "index" fund). The only difference between that and a "naive" buy&hold strategy (ie unrebalanced) is that the "naive" buy&hold strategy involves plowing all the dividends back into the same assets that paid them (ie stock dividends to purchase more stocks and bond dividends to purchase more bonds) whereas Sharp is simply saying that all cash flow should simply be reinvested in whatever proportions the principle currently has.
bobcat2 wrote:Sharpe is suggesting that institutional investors, not individual investors, would be better served by rebalancing to market proportions rather than set asset allocations. I believe Sharpe would agree that Merton's method is the best way for individuals to rebalance their portfolios. You have a finite amount of time to reach fairly specific retirement goals in your personal portfolio. Institutional investors OTOH often have for practical purposes near infinite time horizons and often less specific goals. Think Yale endowment.
Merton's is a liability matching strategy and Sharpe's is a market theory strategy. So whether or not individuals should employ Sharpe's strategy depends on whether or not they want to employ liability matching. But isn't it a bit futile to try to do liability matching with something as unwieldy as stocks?

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Re: Rebalancing theory

Post by richard » Wed May 30, 2012 12:15 pm

bobcat2 wrote:Sharpe is suggesting that institutional investors, not individual investors, would be better served by rebalancing to market proportions rather than set asset allocations. I believe Sharpe would agree that Merton's method is the best way for individuals to rebalance their portfolios.
I don't see anything in the paper that suggests he's talking to institutions rather than individuals. He explicitly says "If you are an average investor, invest in market average proportions, and live with the changes in the markets."

The average investor holds securities in market proportions, by definition. If you believe markets are efficient, then the average investor should hold in market proportions. As John Cochrane says "Do not forget, the average investor holds the market. If you’re pretty much average, all this thought will lead you right back to holding the market index. To rationalize anything but the market portfolio, you
have to be different from the average investor in some identifiable way."

Doing nothing typically leaves you holding market weights, which shifts stock/bond allocations up and down. It typically requires active management of your portfolio to change this, although sometimes new issuances, stock buybacks and debt reaching maturity brings you out of whack, in which case you have to act to get back in sync.

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Re: Rebalaning theory

Post by richard » Wed May 30, 2012 12:17 pm

Dave_HowWealthWorks.com wrote:So Sharp is simply saying that the overall portfolio should be managed just like any other cap-weighted index fund (instead of using a contrarian trading strategy to rebalance like an equal weighted "index" fund). The only difference between that and a "naive" buy&hold strategy (ie unrebalanced) is that the "naive" buy&hold strategy involves plowing all the dividends back into the same assets that paid them (ie stock dividends to purchase more stocks and bond dividends to purchase more bonds) whereas Sharp is simply saying that all cash flow should simply be reinvested in whatever proportions the principle currently has.
Yep.

Vanguard total stock market holds US stock in market proportions. Sharpe is just extending the concept to one's entire portfolio. Doing otherwise is active management.

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Re: Rebalaning theory

Post by richard » Wed May 30, 2012 12:19 pm

tetractys wrote:So then how exactly would someone do this?
Usually, by doing nothing. You only have to act when you have new cash or when securities are created or disappear.

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Re: Rebalaning theory

Post by yobria » Wed May 30, 2012 12:27 pm

Dave_HowWealthWorks.com wrote:So Sharp is simply saying that the overall portfolio should be managed just like any other cap-weighted index fund (instead of using a contrarian trading strategy to rebalance like an equal weighted "index" fund). The only difference between that and a "naive" buy&hold strategy (ie unrebalanced) is that the "naive" buy&hold strategy involves plowing all the dividends back into the same assets that paid them (ie stock dividends to purchase more stocks and bond dividends to purchase more bonds) whereas Sharp is simply saying that all cash flow should simply be reinvested in whatever proportions the principle currently has.
Ok, I didn't get that from Richard's quote, but that would seem to be a matter of personal preference. If a certain portfolio volatility allows me to sleep at night, I might want to maintain that volatility, though I see that, unless you assume an RTM world, there's no theoretical basis for this.

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Re: Rebalaning theory

Post by bobcat2 » Wed May 30, 2012 12:29 pm

Here is Cochrane discussing Merton's model. If the goal of your portfolio is to optimize your lifetime living standard then you will try to approximate Merton's rebalancing method. If your goal is just to look like you are doing something helpful and thoughtful, then rebalance to a constant AA. Rebalancing to a constant AA will only be optimal under very restricted conditions which are rarely met in the world we live in. Whether it helps, hurts, or makes little difference over time is pretty much a random result.

Link to Cochrane paper.
http://faculty.chicagobooth.edu/john.co ... o_text.pdf

Link to several sources concerning rebalancing and the Merton model.
https://www.google.com/#hl=en&gs_nf=1&g ... qf.,cf.osb

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Re: Rebalaning theory

Post by richard » Wed May 30, 2012 12:39 pm

bobcat2 wrote:Rebalancing to a constant AA will only be optimal under very restricted conditions which are rarely met in the world we live in. Whether it helps, hurts, or makes little difference over time is pretty much a random result.
Yep.

As mentioned, it does have the advantages of simplicity and the appearnig to be doing something useful.

I'll add Cochrane on Merton to the list. Care to give us the two paragraph version?

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Re: Rebalaning theory

Post by richard » Wed May 30, 2012 12:43 pm

yobria wrote:If a certain portfolio volatility allows me to sleep at night, I might want to maintain that volatility, though I see that, unless you assume an RTM world, there's no theoretical basis for this.
How would you maintain a specified portfolio volatility? A constant asset allocation is no guarantee.

Why choose volatility, rather than some other proxy for risk, although there's nothing which says any particular asset or portfolio will maintain a constant level of risk. Which is really the key point - a constant asset allocation gives you neither constant risk nor constant expected returns.

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Re: Rebalancing theory

Post by DRiP Guy » Wed May 30, 2012 12:47 pm

bobcat2 wrote:The concept of rebalancing a portfolio does not come from personal finance common sense wisdom. It comes instead from a paper on the life-cycle model of personal finance written by Robert Merton around 1970. One of the things that fell out of Merton's optimal control solution to his life-cycle model was that the household's portfolio of financial assets should be continuously rebalanced to keep the portfolio on target to meet its financial goals. In the usual case of a portfolio primarily for retirement this means rebalancing the portfolio frequently to keep the portfolio on target to meet its retirement income goals - both floor and aspirational.

Since financial practitioners didn't and don't know how to rebalance a portfolio to meet income goals (or for that matter even have income goals), they settled instead on the simplistic strategy of rebalancing assets to a set AA, or a predetermined schedule of asset allocations over time.

Sharpe is suggesting that institutional investors, not individual investors, would be better served by rebalancing to market proportions rather than set asset allocations. I believe Sharpe would agree that Merton's method is the best way for individuals to rebalance their portfolios. You have a finite amount of time to reach fairly specific retirement goals in your personal portfolio. Institutional investors OTOH often have for practical purposes near infinite time horizons and often less specific goals. Think Yale endowment.

BTW the Dimensional DC Managed Retirement plan rebalances the participant's portfolio monthly in a manner consistent with Merton's paper. There is no surprise here, since Merton designed the Dimensional DC Managed retirement plan.

There is no justification in financial theory for rebalancing to a set AA. Sometimes it helps; sometimes it makes little difference; and sometimes it makes things worse. However, if someone is getting paid to manage your portfolio it may seem that he is doing something important to help justify his fee when he rebalances your portfolio. :wink:

BobK
Not gainsaying anything, but a simple exercise might suffice to illustrate a point:

I think most would say that a 20 year old up and comer would not be likely to apply the same allocation of stocks to bonds etc as would be appropriate for a late aged retiree of 90 years old. (If you disagree, then we can stop here.)

If you agree with that, then it's simply a matter of when and how to make the required changes over time. Annual rebalancing to the *current* risk profile required to meet one's goals seems prudent, even if overt evidence it will help the returns for every individual investor may be difficult or even impossible to obtain.

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Re: Rebalaning theory

Post by yobria » Wed May 30, 2012 12:56 pm

bobcat2 wrote:Here is Cochrane discussing Merton's model. If the goal of your portfolio is to optimize your lifetime living standard then you will try to approximate Merton's rebalancing method. If your goal is just to look like you are doing something helpful and thoughtful, then rebalance to a constant AA.
This model seems to divide anyone who's ever rebalanced into two categories: a) Those who know all their future variables and have plugged them into Merton's model (ie no one), and b) Irrational buffoons. Since I can think of many good reasons to rebalance (see my response above), I wouldn't agree with this.

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Re: Rebalaning theory

Post by fundtalker123 » Wed May 30, 2012 1:03 pm

Hi, I posted the link to the quote in another tread. My take is Sharpe is saying is that 70/30 today is not an equivalent asset allocation to 70/30 tomorrow after stock and bond prices have changed. If allocation is supposed to be related to risk, that makes sense.

If you decide that it is "CORRECT" ON A PARTICULAR DAY for your asset allocation to be 70/30, then the EQUIVALENT asset allocation later is WHATEVER IT IS (without rebalancing) at that later point, as determined by the market, which prices stocks and bonds more accurately than a person can no matter how smart you think you are.

It is a pretty compelling argument.

However I'm admittedly at a loss to decide how to chose my "correct" asset allocation should be on a particular day...if staying 70/30 actually corresponds to jumping around, it still feels comfortable...but maybe this is just because I've been indoctrinated that this is the right thing to do.

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Re: Rebalancing theory

Post by bobcat2 » Wed May 30, 2012 1:12 pm

One rebalances a portfolio over time to optimize your lifetime living standard, and in some cases also for estate purposes. So you would only be rebalancing to a set schedule of asset allocations (whether constant or varying) over your lifetime if your initial plan perfectly foresaw the rest of your financial life. That is unlikely. It's the dynamics of real life that make this complicated. If life could realistically be represented in a fairly static one period or two period analysis then this type of simple rebalancing might be valuable. Financial life, unfortunately, is not that simple.

We have a quandary. Merton style rebalancing that is valuable and consistent with financial theory is difficult to do. Rebalancing to a constant AA is easy to do, but there is no reason in theory that demonstrates that you are accomplishing much, if anything. Empirically Sharpe and others have shown that in some situations such a simple rebalancing strategy helps, in other situations it makes things worse, and in some situations it makes little difference. Life should be easier. :|

One point about this that I want to reiterate is that the concept of rebalancing a portfolio came from an early Merton paper on the life-cycle model, which I think was published in 1969. Before that paper to the best of my knowledge the idea of rebalancing a portfolio had never been considered. So all ideas about portfolio rebalancing flow from the original Merton approach of using portfolio rebalancing to optimize consumption over the life-cycle of the household.

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Re: Rebalaning theory

Post by yobria » Wed May 30, 2012 1:12 pm

fundtalker123 wrote:Hi, I posted the link to the quote in another tread. My take is Sharpe is saying is that 70/30 today is not an equivalent asset allocation to 70/30 tomorrow after stock and bond prices have changed. If allocation is supposed to be related to risk, that makes sense.

If you decide that it is "CORRECT" ON A PARTICULAR DAY for your asset allocation to be 70/30, then the EQUIVALENT asset allocation later is WHATEVER IT IS (without rebalancing) at that later point, as determined by the market, which prices stocks and bonds more accurately than a person can no matter how smart you think you are.
Again, for me anyway, when we're talking about assets within a risky class, I do take the position that the market is smarter than I am. If the S&P 500 went up today, it did so for a reason. Among classes, though, we're talking about risk control and volatilty. If I win the lottery, I may choose a 100% bond portfolio. That doesn't mean I have a view on how accurately other classes are valued. I just have no need to take risk anymore.

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Re: Rebalaning theory

Post by richard » Wed May 30, 2012 1:24 pm

fundtalker123 wrote:Hi, I posted the link to the quote in another tread. My take is Sharpe is saying is that 70/30 today is not an equivalent asset allocation to 70/30 tomorrow after stock and bond prices have changed. If allocation is supposed to be related to risk, that makes sense.

If you decide that it is "CORRECT" ON A PARTICULAR DAY for your asset allocation to be 70/30, then the EQUIVALENT asset allocation later is WHATEVER IT IS (without rebalancing) at that later point, as determined by the market, which prices stocks and bonds more accurately than a person can no matter how smart you think you are.

It is a pretty compelling argument.

However I'm admittedly at a loss to decide how to chose my "correct" asset allocation should be on a particular day...if staying 70/30 actually corresponds to jumping around, it still feels comfortable...but maybe this is just because I've been indoctrinated that this is the right thing to do.
It is a pretty compelling argument (at least, for some of us). Thanks again for the link

There really isn't any good way to choose an asset allocation. It's much more an art than a science.

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Re: Rebalaning theory

Post by bobcat2 » Wed May 30, 2012 1:26 pm

This model seems to divide anyone who's ever rebalanced into two categories: a) Those who know all their future variables and have plugged them into Merton's model (ie no one), and b) Irrational buffoons. Since I can think of many good reasons to rebalance (see my response above), I wouldn't agree with this.
This is entirely backwards. Merton's rebalancing means that you are rebalancing your portfolio to stay on track to meet your goals. So there is no set allocation thru time. You are rebalancing as things change to stay on track to meet your goals. The whole point of Merton rebalancing is that the world we live in is dynamic and we need to be making adjustments to our portfolio frequently to keep on track to meeting our goals as best we can. Rebalancing to a set AA, regardless of what happens, in no way takes account of changing conditions. It is the epitome of a static allocation that ignores the dynamics of the real world we all live in.

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Re: Rebalaning theory

Post by yobria » Wed May 30, 2012 1:35 pm

bobcat2 wrote:
This model seems to divide anyone who's ever rebalanced into two categories: a) Those who know all their future variables and have plugged them into Merton's model (ie no one), and b) Irrational buffoons. Since I can think of many good reasons to rebalance (see my response above), I wouldn't agree with this.
This is entirely backwards. Merton's rebalancing means that you are rebalancing your portfolio to stay on track to meet your goals. So there is no set allocation thru time. You are rebalancing as things change to stay on track to meet your goals. The whole point of Merton rebalancing is that the world we live in is dynamic and we need to be making adjustments to our portfolio frequently to keep on track to meeting our goals as best we can. Rebalancing to a set AA, regardless of what happens, in no way takes account of changing conditions. It is the epitome of a static allocation that ignores the dynamics of the real world we all live in.
And that seems like one valid way to invest. Your post seemed to indicate that it was the only way.

For example, I have no idea what the future holds, so I'll maintain a 60/40 port. Simple, gives me a risk profile that allows me to sleep at night.

Is this a rational, valid strategy, in your view?

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Re: Rebalaning theory

Post by Dave_HWW » Wed May 30, 2012 2:06 pm

yobria wrote: Ok, I didn't get that from Richard's quote, but that would seem to be a matter of personal preference. If a certain portfolio volatility allows me to sleep at night, I might want to maintain that volatility, though I see that, unless you assume an RTM world, there's no theoretical basis for this.
But rebalancing to a fixed percentage allocation doesn't maintain a constant volatility. And more importantly, as noted above by Sharpe (and elsewhere by Bogle), rebalancing is really not that much different from just letting it float anyway.

Bottom line is that in the long term the unrebalanced market portfolio generally hovers around roughly fixed percentage (~60/40) which implies that, no matter what allocation you hold, you don't need to rebalance to maintain a roughly fixed percentage in the long term either as long as you don't go investing the dividends in assets that are contrary to the market. So the story of rebalancing is simply the same story as all these other illusory "must do" active trading practices: it all comes back to the dividends and what you do with them (for example, the SCV effect is also really nothing more than a thought experiment of what happens when we ignore market impact and imagine juicing an illiquid mirage with the real cash dividends actually paid by liquid stocks).
yobria wrote: Again, for me anyway, when we're talking about assets within a risky class, I do take the position that the market is smarter than I am. If the S&P 500 went up today, it did so for a reason. Among classes, though, we're talking about risk control and volatilty. If I win the lottery, I may choose a 100% bond portfolio. That doesn't mean I have a view on how accurately other classes are valued. I just have no need to take risk anymore.
But how do you know that bonds are always safer than stocks? Would you invest your lotto winnings into a 100% domestic bond portfolio if you were Greek?

Mind you Sharpe isn't saying that everyone should hold stocks/bonds at cap-weight. He's saying you should let your allocation wax and wane as the market's assessment of the risks wax and wane. Obviously if you don't want to take risk you should hold safer assets, but if the level of safety provided by 70% bonds today requires 80% or 60% bonds tomorrow then that's also what you should hold (which means you shouldn't rebalance).
bobcat2 wrote: This is entirely backwards. Merton's rebalancing means that you are rebalancing your portfolio to stay on track to meet your goals. So there is no set allocation thru time. You are rebalancing as things change to stay on track to meet your goals. The whole point of Merton rebalancing is that the world we live in is dynamic and we need to be making adjustments to our portfolio frequently to keep on track to meeting our goals as best we can.
In other words, Merton is doing liability matching, but the downside of liability matching is that it creates an opportunity for active traders (and therefore also the indexers who ride on their coattails) to eat your lunch. Sharpe's strategy, on the other hand, is resistant to the lunch eating ability of the efficient market even though it still gives enough wiggle room to customize a portfolio according to individual risk tolerance (via the initial or subsequent allocation decisions which are then allowed to evolve undisturbed by rebalancing).

Just think of all those insurance companies and pension funds that are currently scrambling to match all their liabilities with treasury bonds....sure they'll meet their goals, but they've also driven down yields so low that they now also need a lot more capital to meet their goals. Now I wouldn't trade against them because they might get lucky and have it turn out that the piss-poor returns they've locked in were better than the alternatives, but by pursuing liability matching and going against the market they're clearly playing with fire.
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Re: Rebalaning theory

Post by bobcat2 » Wed May 30, 2012 2:14 pm

What is 60/40 supposed to accomplish? 60/40 is an input to the plan - not an output.

Target date fund aficionados like to talk about the glide path of such funds. 60/40 is the speed of the target date flight? What is the target date flight's destination? Target date funds don't have a destination - it's wherever?? What is your destination that the 60/40 input puts you on target to reach?

If sleeping well at night is your only goal, why not go to 20/80 and sleep like a cherub?

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Re: Rebalancing theory

Post by bobcat2 » Wed May 30, 2012 2:38 pm

Merton's rebalancing came out of a theory of how to optimize one's lifetime living standard. BTW it isn't purely a matching strategy, or it wouldn't include equities. Rebalancing to a constant AA, as far as I can tell, comes out of wild hand waving. Rebalancing to a constant AA doesn't come out of financial theory, because there isn't any coherent theory there.

Sharpe's strategy makes some sense as long as I don't have goals I want to reach. If I actually have goals I want to reach, why would I pursue this strategy? It is easy to see that Sharpe intends this strategy for institutions and not individuals. That's because this Sharpe strategy is completely at odds with Sharpe's lock box strategy for individuals investing for retirement. Sharpe's lock box strategy is a combination of matching and diversification strategies for retirement income planning. Match for the floor retirement income and diversify for the retirement income above the floor is basically the lock box strategy.

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Re: Rebalaning theory

Post by bertilak » Wed May 30, 2012 4:13 pm

fundtalker123 wrote:Hi, I posted the link to the quote in another tread. My take is Sharpe is saying is that 70/30 today is not an equivalent asset allocation to 70/30 tomorrow after stock and bond prices have changed. If allocation is supposed to be related to risk, that makes sense.

If you decide that it is "CORRECT" ON A PARTICULAR DAY for your asset allocation to be 70/30, then the EQUIVALENT asset allocation later is WHATEVER IT IS (without rebalancing) at that later point, as determined by the market, which prices stocks and bonds more accurately than a person can no matter how smart you think you are.

It is a pretty compelling argument.

However I'm admittedly at a loss to decide how to chose my "correct" asset allocation should be on a particular day...if staying 70/30 actually corresponds to jumping around, it still feels comfortable...but maybe this is just because I've been indoctrinated that this is the right thing to do.
I've posted about this paper in the past but no one seemed to care enough to comment. You have stirred up some action!

You are exactly where I am in trying to decide what to do about this Sharpe paper. I find the concept of maintaining the cap-weighted balance (by doing nothing) to be quite compelling -- just as compelling as why we like cap-weighted funds. But like you, I have trouble discovering the just-right-for-me allocations. If it is constantly drifting about how do I know today's 70/30 is more or less right than last year's 70/30? Did I pick 70/30 based on old, static, info instead of today's real risk/reward ratios? Probably. Can I think of anything to do about that? No. Are Vanguard's (and others') Monte Carlo simulations flawed by assuming a constant, fixed, allocation ratio for the whole simulation? Maybe.

Perhaps the advice to "don't just do something, stand there" applies, but who knows if we first stood in the right spot to begin with?

The paper has a graph that shows how a 60/40 allocation has drifted quite a bit over a number of years -- more than I would have expected.
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Re: Rebalancing theory

Post by DRiP Guy » Wed May 30, 2012 4:24 pm

bobcat2 wrote: I want to reiterate is that the concept of rebalancing a portfolio came from an early Merton paper on the life-cycle model, which I think was published in 1969. Before that paper to the best of my knowledge the idea of rebalancing a portfolio had never been considered. So all ideas about portfolio rebalancing flow from the original Merton approach...
BobK
And I will (gently and politely) reiterate that I am not so sure your logic is sound, there.

The fact a LATER independent rationale and support for rebalancing for individual investors came to pass, I think does not somehow automatically mean that those ideas must somehow have emerged from the same single source you cite.

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Re: Rebalaning theory

Post by DRiP Guy » Wed May 30, 2012 4:28 pm

bobcat2 wrote:If sleeping well at night is your only goal, why not go to 20/80 and sleep like a cherub?

BobK
That's likely not ever the only goal, as most do need capital appreciation, albiet sometimes pretty modest - like pacing inflation, but I think that is an important point, and one I often try to get to -- if you are already taking sufficient risk in your portfolio to be in a position to VERY likely meet your financial goals, then why would you take any more, thereby putting the 'nearly certain' into the category of 'likely less certain' all to be closer to a returns 'optimizing' strategy?

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Re: Rebalaning theory

Post by yobria » Wed May 30, 2012 4:31 pm

Thanks for the responses all. I now know there's something seriously wrong with my set-an-AA-and-rebalance strategy. But since I haven't quite put my finger on the problem, I'll stick with it for now. If I end up destitute in my old age, I'll know what to blame ;) .

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Re: Rebalaning theory

Post by jginseattle » Wed May 30, 2012 7:29 pm

A big part of the problem is that risk varies with time.

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Re: Rebalaning theory

Post by grabiner » Wed May 30, 2012 8:02 pm

William Sharpe wrote:The argument against a constant mix strategy is that if, for example, you set a target of 60% equities and 40% bonds, and the prices of equities rise (and the prices of bonds don’t), then you have to sell stocks and buy bonds. If everyone had a constant mix strategy they would all try to follow that pattern, and there would be a lack of buyers and sellers on the other side of the trades. Not everyone can follow that strategy, and sell what has risen while buying what has fallen. Thus it involves betting against the market. The same argument also applies to target date and life cycle funds. If the market moves sharply, they will have to sell the relative winner and buy the relative loser.
This is an example of the fallacy of composition; what you do as an individual has very different effects if everyone does it. It is analogous to the argument that index funds would not work if everyone used them; while true, it is irrelevant to your decision whether to index when only 15% of stock investments are indexed.
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Re: Rebalaning theory

Post by richard » Wed May 30, 2012 8:16 pm

jginseattle wrote:A big part of the problem is that risk varies with time.
Yep.

In the first post of this thread I wrote "Conventional wisdom on this board is to have a set asset allocation and to periodically rebalance to that allocation. The typical reason is to maintain a constant level of risk (some say it gets the benefit of a "rebalancing bonus" which is another topic).

The constant level of risk argument implicitly assumes that stocks and bonds have constant risk levels, or at least constant relative risk levels. I can't find any good theoretical basis for this view. The main support I find is that rebalancing to fixed percentages is easy."

If anyone has pushed back against this, I've missed it.

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Re: Rebalaning theory

Post by richard » Wed May 30, 2012 8:23 pm

grabiner wrote:
William Sharpe wrote:The argument against a constant mix strategy is that if, for example, you set a target of 60% equities and 40% bonds, and the prices of equities rise (and the prices of bonds don’t), then you have to sell stocks and buy bonds. If everyone had a constant mix strategy they would all try to follow that pattern, and there would be a lack of buyers and sellers on the other side of the trades. Not everyone can follow that strategy, and sell what has risen while buying what has fallen. Thus it involves betting against the market. The same argument also applies to target date and life cycle funds. If the market moves sharply, they will have to sell the relative winner and buy the relative loser.
This is an example of the fallacy of composition; what you do as an individual has very different effects if everyone does it. It is analogous to the argument that index funds would not work if everyone used them; while true, it is irrelevant to your decision whether to index when only 15% of stock investments are indexed.
It's a bit odd to criticize a statement that says everyone can't do something by saying an individual can do that thing.

If markets are efficient, it may make sense to deviate from the market, but only if you're meaningfully different from the representative investor.

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Re: Rebalancing theory

Post by Taylor Larimore » Wed May 30, 2012 8:35 pm

Bogleheads:

When experts disagree (Sharpe and Merton are Nobel Lauretes) it is often because it does not make much difference.

Best wishes
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Re: Rebalancing theory

Post by bobcat2 » Wed May 30, 2012 8:42 pm

Sharpe and Merton do not disagree. Sharpe's lock box approach to retirement finance is one way to implement the type of rebalancing derived from the results of Merton's portfolio rebalancing in the life-cycle model.

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Re: Rebalaning theory

Post by yobria » Wed May 30, 2012 8:44 pm

richard wrote:
grabiner wrote:
William Sharpe wrote:The argument against a constant mix strategy is that if, for example, you set a target of 60% equities and 40% bonds, and the prices of equities rise (and the prices of bonds don’t), then you have to sell stocks and buy bonds. If everyone had a constant mix strategy they would all try to follow that pattern, and there would be a lack of buyers and sellers on the other side of the trades. Not everyone can follow that strategy, and sell what has risen while buying what has fallen. Thus it involves betting against the market. The same argument also applies to target date and life cycle funds. If the market moves sharply, they will have to sell the relative winner and buy the relative loser.
This is an example of the fallacy of composition; what you do as an individual has very different effects if everyone does it. It is analogous to the argument that index funds would not work if everyone used them; while true, it is irrelevant to your decision whether to index when only 15% of stock investments are indexed.
It's a bit odd to criticize a statement that says everyone can't do something by saying an individual can do that thing.

If markets are efficient, it may make sense to deviate from the market, but only if you're meaningfully different from the representative investor.
I see shopping for investments like shopping for consumer items. Everyone will own a different combination based on their preferences. Since there are no free lunches, and the future can't be known, there's clearly no right or wrong answer.

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Re: Rebalancing theory

Post by richard » Wed May 30, 2012 8:59 pm

bobcat2 wrote:Sharpe and Merton do not disagree. Sharpe's lock box approach to retirement finance is one way to implement the type of rebalancing derived from the results of Merton's portfolio rebalancing in the life-cycle model.
Neither Sharpe nor Merton recommend rebalancing to fixed percentages.

Sharpe is recommending holding either holding the market portfolio, which essentially doesn't require rebalancing (it automatically corrects), or holding more safe assets as one ages, then adjust per market changes. The former is a straight efficient markets result.

Graham, to pick the first early finance writer I thought of, was recommending holding a 50/50 portfolio (or between a 25/75 to 75/25 portfolio) decades before 1970, the date you say Merton invented rebalancing. Did I misunderstand your earlier statement?

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Re: Rebalancing theory

Post by xerty24 » Wed May 30, 2012 9:41 pm

Richard - I see what you're saying. If the point of AA is risk control, it's really a proxy for fixing a risk level for your portfolio and trying to keep that constant. Now sometimes stocks go up and sometimes they go down, and they can do either without their "risk level" changing in a meaningful way. In those circumstances, a constant-risk investor would want to rebalance.

However, sometimes the world just gets more risky. Look at 2008 or now with Greece in the EU. Risk is up, and if you dont want that much of it, you should consider selling stocks for bonds, or at the very least not rebalancing into a decline. Measures like the VIX or similar statistics from stock and bond options markets should give a good 1 year forward looking estimate for the near term risks perceived in the market. Those could be used prospectively to adjust your AA or decide whether or not to rebalance.
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Re: Rebalancing theory

Post by Malachi » Wed May 30, 2012 9:44 pm

When people say "hold the market portfolio", presumably that means stocks and bonds relative to each other.

How does one maintain that balance? Presumably, given enough time, stocks will outgrow bonds in your portfolio but that does not mean that, during the same period of time, the stock market outgrew the bond market in their relative sizes to each other. As companies grow, they correspondingly take on more debt.

So, the need for periodic rebalancing still exists. The difference, as I see it, is that the ratio is determined by the market.

How do we determine that ratio?

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Re: Rebalancing theory

Post by Taylor Larimore » Wed May 30, 2012 9:46 pm

When experts disagree (Sharpe and Merton are Nobel Lauretes) it is often because it does not make much difference. Taylor
Sharpe and Merton do not disagree. Sharpe's lock box approach to retirement finance is one way to implement the type of rebalancing derived from the results of Merton's portfolio rebalancing in the life-cycle model. BobK
BobK:

I was not referring only to Sharpe & Merton. I think you must agree that financial experts seldom agree exactly about the best way to rebalance portfolios. Few subjects bring more controversy than the best way to "rebalance" portfolios.

Best wishes.
Taylor
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Re: Rebalancing theory

Post by bobcat2 » Wed May 30, 2012 10:14 pm

There is general agreement among financial economists that rebalancing to a set AA does not accomplish much. There is no theoretical reason this should accomplish much. If a market has a lot of up and down movement it will work well. If a market has a strong upward trend it does not work well. If a market has a strong downward trend it does not work well. Over extended periods markets can exhibit any of these behaviors.

I am sure that a lot of financial professionals believe this works based on theories of furious hand waving. And why shouldn't they want to believe this works, they are justifying some of their fees on the proposition that this works. :wink:

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Re: Rebalancing theory

Post by bobcat2 » Wed May 30, 2012 10:15 pm

Recommending holding a portfolio between 25/75 and 75/25 is not the same as recommending regular rebalancing. Setting such general guidelines isn't the same thing as a rebalancing strategy. For those who think Sharpe is recommending something different for individual investors than Merton, how do you reconcile that with Sharpe's lock box approach for retirement income? Sharpe's lock box approach is quite consistent with the type of rebalancing that comes out of the life-cycle model approach to personal finance and that was first presented by Merton over 40 years ago. The lock box approach has nothing in common with Sharpe's advice to institutional investors or to individual investors with more than $100 million in investible assets. If you are a mega millionaire the life-cycle advice to individual investors doesn't apply. At those asset levels you are doing more than investing for a comfortable retirement and a pleasant living standard before retirement. :)

I really don't care that much whether I am in line with the market or not. Mr. Market also doesn't care that much if my personal portfolio is in line with the market. I do care that my portfolio helps me reach my goals. If OTOH I am in charge of a multi-billion portfolio for a large medical center or a college then I, and perhaps Mr. Market, are looking to see if I being consistent with the makeup of the macro market.

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Re: Rebalancing theory

Post by dolio » Wed May 30, 2012 10:38 pm

I must be missing something. How are price movements related to riskiness? Even if the relative risk of stocks vs. bonds varies, it doesn't need to vary according to relative price changes. So if you want to keep a constant risk, you'd be rebalancing based on risk changes, not not-rebalancing based on price changes, right?

Or is the point that: on a given day, I decided that 70/30 was the right risk level. Then stocks go up 100%, so I'm at 82/18, so if I go back to 70/30, I'm actually at less risk than I was initially, because I have significantly more money in the same proportions, so my chances of ending up at a given amount below my initial investment are lower. And the opposite happens if stocks fall relative to bonds and I rebalance.

The latter makes some sense to me, but the rebalancing to a fixed percentage could be motivated by the fact that if I get lucky, I'm okay sitting on it with less risk, because I'm closer to my goal, and don't need to take as many risks (and the opposite for losses). Similar to the lottery example. If 50/50 suddenly became 99/1 (due to stock increase), one might rebalance to even lower than 50/50, because why not? At that point the person could possibly live on treasury coupons for the rest of his/her life.

Of course, lowering your risk after a windfall (where your downside is losing out on some gains you are now less in need of) seems more advisable than increasing your risk after something bad happens (where your downside is ending up even further in the hole if you adjust in the middle of the movement).

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Re: Rebalancing theory

Post by tetractys » Wed May 30, 2012 11:57 pm

richard wrote:The constant level of risk argument implicitly assumes that stocks and bonds have constant risk levels, or at least constant relative risk levels.
This statement is incorrect because it attempts to lump two different uses of the word "risk" into one use. For portfolio allocation, the riskiness is derived from historical averages. Bonds are less risky than stocks, etc. Another use of "risk" is by looking at valuations. The P/E of the S&P is 58 today, and seems kind of risky.

Maintaining an asset allocation exploits both these uses. Rebalancing readjusts portfolio risk in accordance with market valuations, by decreasing the risk of owning to many high valued assets, and increasing the risk of owning not enough low valued assets.

Sharpe's method of owning the whole market, or a cap weighting of all stocks and bonds, produces a set asset allocation of a single world risk level, which constantly varies depending on circumstances--a blob without any single investor's needs taken into consideration.

That's a great idea for an investment company pursuing an infinite cliental of deep pocketed lemmings. -- Tet

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Re: Rebalaning theory

Post by tetractys » Thu May 31, 2012 12:26 am

richard wrote:
tetractys wrote:So then how exactly would someone do this?
Usually, by doing nothing. You only have to act when you have new cash or when securities are created or disappear.
A strange contradictory statement. I guess the "doing nothing" would be giving up making a living since that time would be needed to "act" about 500 times more often than I am now keeping a fairly constant asset allocation.

Assimilating with Financial Engine's world cap blob actually sounds like a better idea. -- Tet

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Re: Rebalancing theory

Post by Dave_HWW » Thu May 31, 2012 12:36 am

tetractys wrote: This statement is incorrect because it attempts to lump two different uses of the word "risk" into one use. For portfolio allocation, the riskiness is derived from historical averages. Bonds are less risky than stocks, etc. Another use of "risk" is by looking at valuations. The P/E of the S&P is 58 today, and seems kind of risky.

Maintaining an asset allocation exploits both these uses. Rebalancing readjusts portfolio risk in accordance with market valuations, by decreasing the risk of owning to many high valued assets, and increasing the risk of owning not enough low valued assets.
Ayai yai. How is this different from what all the other active managers do who claim their strategies/exploitations are simply "risk management"?
tetractys wrote: Sharpe's method of owning the whole market, or a cap weighting of all stocks and bonds, produces a set asset allocation of a single world risk level, which constantly varies depending on circumstances--a blob without any single investor's needs taken into consideration.
This isn't true at all. In general Sharpe does NOT recommend cap-weighting the stock/bond ratio but instead recommends selecting it specifically based on the needs of each individual investor and only then allowing it to automatically adjust in response to the constantly varying risks and investment circumstances. Only for average investors with average needs does this correspond to cap-weighting the stock/bond ratio, but for everyone else it's different because the initial conditions are different (even though the evolution from those initial conditions is the same).

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Re: Rebalancing theory

Post by wintermute » Thu May 31, 2012 1:32 am

I wonder how a portfolio with that quant momo fund performs, with and without rebalancing, and vs Sharpe's new strategy. That might provide some insight.

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Eric Haas's "Reading Room"

Post by Taylor Larimore » Thu May 31, 2012 5:29 am

Bogleheads:

Eric Haas, has a "Reading Room" with a very fine collection of articles by investment authorities. This is a link to the "Rebalancing" articles:

http://www.altruistfa.com/readingroomar ... ebalancing

There is more than one road to Dublin.

Best wishes.
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Re: Rebalancing theory

Post by richard » Thu May 31, 2012 6:07 am

dolio wrote:I must be missing something. How are price movements related to riskiness? Even if the relative risk of stocks vs. bonds varies, it doesn't need to vary according to relative price changes. So if you want to keep a constant risk, you'd be rebalancing based on risk changes, not not-rebalancing based on price changes, right?
There is likely no feasible way to keep a constant risk level. 70/30 is a constant asset allocation, not a constant level of risk.

The risk of stocks is not constant over time, the risk of bonds is not constant over time and the relative risk of stocks and bonds is not constant over time.

If you are an average investor and markets are efficient, then the market allocation between stocks and bonds, at any point in time, is represents an appropriate level of risk for you. If you are meaningfully different from the average investor, then another proportion represents an appropriate level of risk for you. As market prices change, causing a change in the relative proportion of stocks and bonds, then this new proportion likely represents an appropriate level of risk for you.

As an empirical matter, the market proportion of stocks and bonds tends to stay in the 60/40 to 40/60 range.

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Re: Rebalancing theory

Post by Slick8503 » Thu May 31, 2012 6:16 am

I see this as Sharpe trying to "sell" his financial engines service to people who might otherwise put the money in their 401k into a target fund with cheaper expenses, and call it good.

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