Hobby Stocks and Rebalancing: Edited

Careful analysis shows us that rebalancing is a mistake except in stressful times. After I wrote this and reflected further, I have now concluded that changing allocations in accordance with P/E10 is always a much better idea. Rebalancing makes sense only if you have no reliable method to take advantage of valuations.

Is rebalancing portfolio allocations a good idea? More and more, the data have been telling me NO!, except under the most stressful conditions. Rebalancing takes far more away from the upside than it gives back in the way of downside protection.

Right now, today, rebalancing is a good idea. These are stressful times. Stock valuations remain in bubble territory. Interest rates are low.

All of this will change. When stock valuations fall down to reasonable levels, even if they remain high, rebalancing will become a bad idea once again.

…I examined whether one should rebalance hobby stocks with his core holdings or whether he should allow them to grow unimpeded.

Most of the time, my answer is: Let them grow.

The Portfolios

Portfolio A was entirely in stocks as represented by the S&P500 index. This corresponds to the hobby stock portion of one’s portfolio.

Portfolio B consisted of 50% stocks and 50% Treasury Bills. It was rebalanced annually. This was the core holding.

The Conditions

I started with an initial balance of $100000. I set the investment expenses at 0.20%.

I allocated 20% of the initial balance to Portfolio A and 80% to Portfolio B.

I withdrew 3%, 4% and 5% of the initial balance (plus inflation) from the individual portfolios in proportion to their balances.

I recorded balances of the combined portfolio at year 30 when I rebalanced Portfolios A and B and when I let them grow separately.

Calculator Conditions

I used the Gummy 04 version of the Deluxe Calculator V1.1A08 dated January 28, 2005. This calculator includes a complete set of Gummy’s data, which can be entered separately as if they were stocks and commercial paper.…

Dollar Allocations

I set the initial balance equal to $100000.

I allocated 20% of this initial balance to portfolio A. This is $20000 in the S&P500 index.

I allocated 80% of this initial balance to portfolio B. This is $80000. It is divided equally between the S&P500 index and Treasury Bills.

Portfolio B started with $40000 in the S&P500 index and $40000 in Treasury Bills.

The combination of the two portfolios started out with $60000 in the S&P500 index and $40000 in Treasury Bills.

Tables

…

Analysis

Only a few conditions show a rebalancing bonus. Those with a bonus show only a small improvement. The sequences with a rebalancing bonus are those associated with high valuations and times of severe portfolio stress: a few years around 1929 and the entire decade of the 1960s.

Typically, there was a penalty for rebalancing. Typically, it was huge.

Conclusions

Except in times of severe portfolio stress, one is better off letting his hobby stocks grow unimpeded.

This happens to be a time of severe portfolio stress. Today’s valuations are higher than during the Great Depression and during the 1960s (and stagflation).

Have fun.

John Walter Russell
I wrote this on February 17, 2005.