To Rebalance or Not? The Moment of Truth

I've read David Swensen, William Bernstein, John Bogle, Larry Swedroe and others and I've "drunk the kool-aid." I'm now a die-hard asset allocator. If you are like me, you've determined an asset allocation that's comfortable for you and invested in index funds or ETFs to execute that allocation.

But if you're truly committed to a strategy of asset allocation, this market brings you to the ultimate moment of truth: Are you willing to rebalance? Markets do ebb and flow over time, and your allocations will shift from target percentages. Rebalancing means taking the counter intuitive action of selling shares of markets that are performing well and buying more shares of ones that have been lagging. The process of rebalancing means that you buy and sell to realign with your target percentages.

Let's assume that you invested $100,000 in our MarketRiders Moderate Portfolio (chart below) which includes the following allocations and ETFs: Bonds (12.5% - BIL, IEI, SHY), TIPS (7.5% - TIP) Commodities (5% - DBP, IXC), Emerging Markets Stocks (7.5% - VWO), Foreign Developed Stocks (12.5% - EFA), Real Estate (10% - RWX, VNQ), and US Stocks (45% - IJH, IJR, SPY).

US stocks and stocks in other developed countries tend to move independently from each other. So you allocated money to both markets and created instant diversification. Emerging markets also move to the beat of a different drummer. Bonds and real estate are even further a field from stocks, so you added these markets too. Historically, every year, some market wins and others lose and no expert can predict the future. So you own them all! Once you set up your portfolio and allocated percentages to various markets, you've let the markets perform pretty much on automatic.

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In the first few weeks of 2008, extreme volatility and uncertainty has taken your well diversified, low fee portfolio down about (7.07%). You're nervous. In fact, you wished that you'd allocated more to bonds.

To rebalance the MarketRiders Moderate Portfolio to the original Target Allocations, you need to make the trades shown below in the "ETF Shares To Buy or Sell" column. You would sell about $1873 of Bonds and TIPs since they have increased from 20% to about 22% of your portfolio. You would purchase $1615 of Foreign Developed and Emerging Markets Stocks since they have decreased from 20% to about 18% of your portfolio. You would also sell some of your Precious Metals and REITs in order to buy more US stocks.

Do you have the stomach to sell what is working and buy what is losing you money? Historically, it is proven to add to your returns but emotionally it's tough.

I've always had more conviction with an asset class than with a stock. For example, buying more Apple Computer (AAPL) on the way down is a bet on Steve Jobs, the products, competition, and the consumer economy. Buying more US Stocks, means you are increasing your bet on the United States economy and thousands of companies in its 10 sectors. As you sell Bonds you are selling them after they've risen as a result of interest rates declining to near historic lows.

So are you rebalancing now? If not, why not?

Comments

[David Jackson:]

Mitch, take a look at Phil DeMuth's attack on rebalancing here:
seekingalpha.com/artic...

Would love to hear your thoughts on it.

2008 Feb 09 05:53 PM

[Mitch Tuchman:]

David - I posted a response. I think his attack is based upon a the theory that a portfolio's amount is "fixed." Frankly I enjoyed your ideas more in your ETF Guide where you use rebalancing to "lean" in and out of allocations based upon an investment thesis for the particular asset class.

2008 Feb 11 08:47 PM