Indexing Worked if You Rebalanced

Includes: BND, DIA, QQQ, SPY, VB, VXF
by: AAII

Index investing was profitable over the last decade for those investors who rebalanced. This was even the case for those investors who owned shares in mutual funds designed to track the performance of the S&P 500.

Yes, the data does show that 2000-2009 was a lost decade for the S&P 500. Passive investing has been unfairly attacked in response to this data, however, because of a misperception of what a proper passive investing strategy is. Passive investing does not mean one should buy-and-forget, but rather that one should limit trading to periodic portfolio rebalancing. Those who proactively rebalanced their portfolios actually profited, even when investing in funds that tracked that S&P 500.

To show how this was possible, I created two simple portfolios, each with a starting balance of $50,000 in the Vanguard 500 Index Investor mutual fund (VFINX) and $50,000 in the Vanguard Total Bond Market Index Investor mutual fund (VBMFX) at the end of 1999. No rebalancing occurred in the first portfolio, meaning any shift in the allocation was caused by market forces. The second portfolio was proactively rebalanced at the end of each calendar year to maintain a 50%/50% split between the two funds. The tables below show how each portfolio performed using annual total return data from Morningstar.

Portfolio #1—No Rebalancing
Starting Value $50,000 $50,000 $100,000
2000 $45,470 $55,695 $101,165
2001 $40,005 $60,390 $100,395
2002 $31,144 $65,378 $96,522
2003 $40,019 $67,974 $107,993
2004 $44,317 $70,856 $115,173
2005 $46,431 $72,556 $118,988
2006 $53,693 $75,655 $129,348
2007 $56,587 $80,890 $137,477
2008 $35,639 $84,975 $120,614
2009 $45,079 $90,014 $135,093
Portfolio Value $45,079 $90,014 $135,093
Total Return -9.8% 80.0% 35.1%
Portfolio #2—Annually Rebalanced to 50%/50% Split
Starting Value $50,000 $50,000 $100,000
2000 $45,470 $55,695 $101,165
2001 $44,502 $54,847 $99,349
2002 $38,672 $53,778 $92,449
2003 $59,399 $48,060 $107,458
2004 $59,500 $56,007 $115,507
2005 $60,508 $59,140 $119,648
2006 $69,180 $62,378 $131,559
2007 $69,325 $70,331 $139,656
2008 $43,978 $73,355 $117,332
2009 $74,207 $62,145 $136,352
Portfolio Value $74,207 $62,145 $136,352
Total Return 48.4% 24.3% 36.4%

As you can see, not only did rebalancing produce impressive returns for the equity portion of the portfolio, it also produced a higher overall return for the portfolio. In other words, there was no lost-decade penalty for allocating to a fund that tracked the S&P 500.

Even if the allocation to equities was increased, the outperformance created by rebalancing still holds. This held true when a 70%/30% split to VFINX and VBMFX was used. It also held true when a 60%/40% split that included small-cap stocks was used (30% in VFINX, 30% in Vanguard Small-Cap Value Index Investor (VISVX) and 40% in VBMFX). Extending the data through November 30, 2010 sustained the trend of outperformance for all three of the aforementioned allocation strategies.

How is this possible? Simple: Asset allocation forces an investor to buy low and sell high. At the end of each calendar year, the investor shifted funds from the better-performing asset class to the worst-performing asset class. This meant being a seller of large-cap stocks at the end of 2006 and a buyer of them at the end of 2008.

The mistake many investors made throughout the last decade is that they didn't proactively rebalance on a regular basis. Some had set their asset allocations at a previous point and never revisited the mixture. Others adjusted their portfolios at the worst possible time, selling stocks when they should have been buying. Compounding matters were incorrect assumptions that diversification failed during the last bear market, as Sam Stovall, chief investment strategist of Standard & Poor's Equity Research, explained in this March 2010 AAII Journal article.

Conversely, those who placed emphasis on how their portfolios were allocated profited. No magical timing strategy was required, just a simple commitment to review the portfolio's allocation on a regular basis and adjust it accordingly.

Keep in mind that any rebalancing strategy will invoke transaction costs, especially if done in a taxable account. The cost of not rebalancing, however, could be greater, especially during periods of stock market turbulence. It is certainly higher for those who sell based on fear about the direction of stock prices.

It should also be noted that the above portfolios were simplistic examples. A properly diversified portfolio would be comprised of a broader array of investments (including foreign stocks and bonds). Furthermore, as an investor ages, the bond allocation would gradually increase on a proportionate basis.

Finally, understand that rebalancing and diversification won't prevent a portfolio from falling in value during periods of market turbulence, especially when stocks are in a bear market. What it will do, however, is help you take advantage of reduced prices and better position your portfolio for the next bull market.