More on 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.

I continue to look at what the data show about rebalancing. My question is this: Is rebalancing portfolio allocations a good idea? In my earlier study, Hobby Stocks and Rebalancing, the answer was NO! except under the most stressful conditions. Rebalancing took away far more from the upside than it gave back in the form of downside protection.

This time I took matters to an extreme. I investigated the rebalancing of mirror portfolios. I looked at both the distribution and accumulation phases.

This is what I mean by mirror portfolios: Portfolio A had 80% stocks and 20% Treasury Bills while Portfolio B had 20% stocks and 80% Treasury Bills.

I rebalanced each individual portfolio annually.

I allowed the two portfolios to grow independently. I compared this to what happens if the two individual portfolios are rebalanced as well.

The Portfolios

Portfolio A consisted of 80% stocks and 20% Treasury Bills. It was rebalanced annually. Stocks were represented by the S&P500 index.

Portfolio B consisted of 20% stocks and 80% Treasury Bills. It was rebalanced annually. Stocks were represented by the S&P500 index.

The Conditions

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

I allocated 50% of the initial balance to Portfolio A and 50% to Portfolio B.

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

For the accumulation phase, I deposited 3%, 4% and 5% of the initial balance (plus inflation) annually to the individual portfolios in proportion to their balances. The calculator treats deposits as negative withdrawals.

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.
…

The calculator automatically rebalances the holdings within a portfolio. It offers a choice as to whether to rebalance between the two portfolios.
…

Dollar Allocations

I set the initial balance equal to $100000.

I allocated 50% of this initial balance to portfolio A. This is $50000. I put 80% of this into the S&P500 index and 20% into Treasury Bills.

I allocated 50% of this initial balance to portfolio B. This is $50000. I put 20% of this into the S&P500 index and 80% into Treasury Bills.

Portfolio A started with $40000 in the S&P500 index and $10000 in Treasury Bills.

Portfolio B started with $10000 in the S&P500 index and $40000 in Treasury Bills.

The combination of the two portfolios started out with $50000 in the S&P500 index and $50000 in Treasury Bills.

Tables for the distribution phase…

Tables for the accumulation phase…

Analysis

During the distribution phase, 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.

This is the same as we have seen before when looking at hobby stocks.

During the accumulation phase, all of the sequences favored leaving the two portfolios alone except for the years 1977-1980. This special behavior for the 1977-1980 sequences is probably an artifact of the calculator. These sequences end at year 30 in 2007-2010. The calculator returns for Portfolio A and Portfolio B have different dummy values in 2001-2010.

Conclusions

During distribution, the message remains unchanged. Except in times of severe portfolio stress, let the two portfolios grow independently.

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).

For those who are still in the accumulation phase, the message is simpler. Allow the two portfolios to grow independently.

Have fun.

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