More from Edesess on Rebalancing

So, one of my complaints about the Edesess article has been answered.  Nothing about risk, you say?  Here’s a whole article on risk and rebalancing, once again concluding that rebalancing is not of any value, and in fact may be harmful.

I think this one is even more misleading, with the same glaring omission of any reference to an intended financial plan, or desirable asset allocation.  There is some analysis of portfolios holding equities and cash, or equities and treasuries, and how they fare over extended time periods.  Which is all well and good except that not many advisors would agree that #1, it’s a responsible idea to increase equity percentage as time progresses, which is the inevitable result over a long enough time period here, and #2,  it’s a good idea to just let whatever happens, happen, as far as asset allocation goes, over the short term or the long term.  It’s generally agreed upon that an individual will be better suited for different asset allocations at different stages of their life, and that asset allocation should be determined and managed throughout the investment timeline, not just once at the beginning.

Then he ends with this really egregious example:

The danger of a worst-case scenario with a rebalancing strategy

Although rebalancing is held forth as a way to control risk, it can – in a worst-case scenario – lead to genuinely dire results in a way that a buy-and-hold strategy cannot. The following is from William Bernstein’s recent short book, “Deep Risk: How History Informs Portfolio Design (Investing for Adults)” (p. 49):

Consider the following exercise; imagine, for a moment, it is June 30, 1929, and you plan to retire in five years and have a $100,000 portfolio that is 75/25 stocks/ bonds; $75,000 of stocks, represented by the CRSP 1-10 index, and $ 25,000 in 5-year Treasury notes, your LMP [Liability Matching Portfolio]. The $25,000 of bonds, you figure, is adequate to pay for 10 years of living expenses, which you estimate at $2,500 per year, a more than adequate outlay in 1929. You are not too concerned by the fact that your LMP will last you only 10 years; you figure you will be able raise additional living expenses by selling your stocks, and you resolve to rebalance your portfolio back to its 75/25 composition every year on June 30.

Here’s how this scenario plays out: By June 30, 1930, stocks have fallen by 26%, so you have to sell $6,528 of your Treasuries to buy more stocks to bring the portfolio back to 75/25. Over the next year, stocks fall another 26%, and on June 30, 1931, you’ve got to sell $4,616 more of those precious Treasuries.

The next 12 months are even more of a disaster, with stocks losing more than 64%. On June 30, 1932, your Treasury stash is worth $16,959, and you calculate that to get back to 75/25, you’ll have to sell $8,357 of them – nearly half of the notes – to toss into what now clearly looks like a deep-risk rat hole. This will leave you just $9,324 in liquid Treasuries – less than four years of living expenses.

Bernstein’s purpose in developing this scenario is, in part, to illustrate the difficulty of determining in real-time whether a stock market incident like that of 1929-32 is an example of “shallow risk” or “deep risk.” Bernstein defines shallow risk as “a loss of real capital that recovers relatively quickly” while deep risk is “a permanent loss of real capital.” If an investor is concerned about deep risk, he or she may be better off with a buy-and-hold strategy than with a rebalancing strategy.

And that’s the end of the example.  But it’s not the end of the scenario, is it?  There are still 2 years left before retirement.  As of June 30, 1933, stocks had more than doubled.  The stock portfolio would have risen to $66,573 by that time.  With rebalancing, you would buy back about $10,000 of the treasuries, and be down overall about 25% from the original $100,000.  Stocks were down about 4% in the fifth and final year before retirement, but if you take out $2,500 per year starting in year 6, and rebalance every year, this portfolio NEVER RUNS OUT OF MONEY.  By 1953 the balance is over $250,000.  Where’s the “deep risk”?  Not only that, but starting in June 1936, the strategy with rebalancing is always worth more in total than the strategy of buy and hold, with spending down the bonds first.  That’s only 4 years after the strategy has been dismissed as a failure by the author.  What “clearly looks like a deep-risk rat hole,” is in fact a great buying opportunity.  Which is where the discipline of rebalancing steps in to override that lizard brain.

He ends with his only mention of considering the investor’s needs:

Neither buy-and-hold nor rebalancing is necessarily the best strategy in all cases. In fact, any strategy will need to be adjusted periodically based on the investor’s circumstances and the investment prospects.

And with that second sentence, pretty much undoes his entire article.



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