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Editor's Note

by Charles Rotblut, CFA

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I now have 25 years of data on portfolio rebalancing. The lesson from the data is very clear: rebalancing lowers portfolio volatility. This benefit occurs regardless of whether you keep your money in your portfolio or you make withdrawals each year.

You can see the numbers and the methodology for rebalancing here. Though the strategy works, many investors don’t rebalance. Jason Hsu of Research Affiliates has some thoughts as to why, and you can see his explanation here. But I have my own opinions, as well.

At the most basic level, I think rebalancing lacks the emotional appeal that many other strategies have. Rebalancing reduces portfolio risk by preserving the benefits of diversification. As such, it is designed neither to maximize absolute returns nor to avoid losses. Rather, it is designed to find a middle ground by seeking good risk-adjusted returns. From a rational point of view, rebalancing is a good strategy.

Reality is different, however. We humans are encoded with a strong sense of risk aversion. Studies show that we react more strongly to losses than to gains. Yet, rebalancing prompts you to buy into falling markets. It is a buy fear, sell greed strategy. As Jason points out, going against the grain can create career risk for financial professionals and marital strife for individual investors.

What’s lost in the arguments against rebalancing is the downside of not rebalancing. Data from both the Investment Company Institute and DALBAR show that many individual investors sell low and buy high. This behavior locks in big losses and misses out on big gains. Compared to this all-to-common behavior, rebalancing makes a lot of sense. Rebalancing gives you a strategy for keeping your emotions out of investing decisions.

For those who want more surety, Robert Muksian of Bryant University has a suggestion: Create your own annuity in retirement by buying zero-coupon Treasury bonds (aka STRIPS). In a follow-up to an article he wrote for last June’s AAII Journal (“A Pseudo-Life Annuity: Guaranteed Income for 35 Years”), Bob explains the impact this strategy will have on the value of your estate at the time of death. Specifically, he addresses the question of whether there is a downside for your heirs. His findings are here.

Speaking of not outliving your savings, John Sweeney of Fidelity took a look at retirement withdrawal rates in both up and down markets. His conclusion was that a 4% to 5% portfolio withdrawal rate (adjusted annually for inflation) could be maintained without completely depleting the portfolio. John’s analysis appears in our latest Retired Investor column here.

Those of you looking for an edge in the markets will want to read to my interview with Roger Ibbotson. Roger is well-known for his studies on historical market data, and he has recent research showing a benefit to buying stocks with lower relative trading volume, or “liquidity.” He believes this is a different investing style that can enhance the returns of other styles, such as value investing. Our discussion starts here. (I explain why liquidity impacts an asset’s valuation in the latest Investor Professor column, which appears here.)

Another strategy that can give you an edge is combining quality growth with low valuation and upward price momentum. New research from Robert Novy-Marx at the University of Rochester finds an advantage to analyzing quality growth, or gross profit divided by total assets. AAII President John Bajkowski reviews Novy-Marx’s research and lists stocks identified by screens based on his research starting here.

Finally, AAII Chairman and Founder James Cloonan discusses risk from the standpoint most investors view it: Is the portfolio now worth more or less? From this vantage point, a portfolio that recouped its bear market losses faster and has gone on to reach higher highs during the recent rebound is less risky than one that has been slower to recover. You can see Jim’s discussion and find out which stocks he has added to the Model Shadow Stock Portfolio here.

Wishing you prosperity,
Charles Rotblut, CFA
Editor, AAII Journal
twitter.com/charlesrotblut

Charles Rotblut, CFA is a vice president at AAII and editor of the AAII Journal. Follow him on Twitter at twitter.com/CharlesRAAII.


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