Jim Otar

Rebalancing Can Be Hazardous to Your Portfolio

I just happened to glance what was written above, so please excuse my late entry.

The most important question you need to ask to yourself is "What is the purpose of my action?"

It may be a simple sell order, or a complicated set of rules that Mr. Daryanani have created which -I think - borders on market timing.

Why do we rebalance?

Accumulation Stage: During the accumulation stage what matters most is the volatility of returns. We try to "manage" it by virtue of asset allocation. In my research in year 2000 (High Expectations and False Dreams, amazon.com), I came to the conclusion the most effective way of rebalancing: 1. If equities were higher by more than 5% from their original asset allocation, then rebalance (sell equity and buy bond) regardless of how frequently it happens; 7 days after the last rebalancing or 7 weeks or 7 months, time is inconsequential. On the other hand if equities were lower by more than 5% from their original asset mix, then rebalance (sell bond and buy equity) not more often than once a year.

Distribution Stage: During the distribution stage, the math turns totally on its head. This is where most academics and other researchers fail, because they still look at the portfolio math from the accumulation mindset; their brains are still wired to Gaussian math.

Once withdrawals start, the most important thing is NOT volatility of returns, but it is the sequence of returns. I have written several articles on that (the luck factor) several years ago (all my articles available on my website for free). Once we talk about the sequence of returns, then you cannot and must not use the Gaussian Monte Carlo simulators, they are just the wrong model. It does not matter whether you run the simulations one thousand times or one million times, it is the wrong model and you will end up with wrong and faulty conclusions and mislead unsuspecting public.

Because the sequence of return is the most important factor, the purpose of rebalancing during the withdrawal stage is to minimize the effect of "bad luck", i.e. the sequence of returns. In short, using my actual market history model, (no MC simulations), I found out that if the withdrawal rate is less than 5% then the negative effects of unfriendly sequence of returns was minimized if you synchronize your rebalancing activity with the Presidential cycle. Hence, I found that the most optimum rebalancing for withdrawal rates 5% or less was to rebalance once every four years at the end of the Presidential election year. I tried hundreds of other permutations, frequencies, cycles, one-way growth, two-way growth etc, but this was the simplest and most effective strategy.

Never rebalance can also work, only if your withdrawal rate is 3% or less and your alpha is +2% or over. But for most client portfolios or diversified index funds, this is not a reality.

On the other hand, once the withdrawal rate exceeds 5%, then you need to rebalance annually, because your high rate of withdrawals are the culprit that creates the "bad" sequence of returns in your portfolio by not allowing your portfolio participate effectively in bullish trends.

Keep it in perspective, on the average, the effect of any rebalancing strategy that I looked at during the distribution stage, based on the market history since 1900 is no more than 4% added portfolio longevity, yet in individual years it may make a huge difference. For example: retire in 1929, initial withdrawal rate 5%, asset mix 40% equity, 60% bond: Annual rebalancing will deplete the portfolio in 22.5 years. On the other hand, rebalancing every four years will deplete the portfolio in 30 years, about 33% improvement. Again, as I said before, during the withdrawal stage don't look at averages, they are meaningless, look at individual years.

And please, stop using Monte Carlo simulations for retirement planning!