The Advantages of Diversification and Rebalancing

Could you please consider having a link to a "printable" copy? This would make it more readable once printed, and would also save me paper! :-)

Thanks,

Liz Bateman

posted about 1 year ago by James from Virginia

Have you done this study with a portfolio diversified in alternative assete classes, such as real estate, commodities, long/short funds, infrastructure, convertible and high yield bonds?

You used a very traditional asset allocation. Would like to see how rebalancing would result in with all these other asset classes.

posted about 1 year ago by Nancy from Maryland

Nice work, Charles. In addition to echoing Nancy from Maryland's comments, I'm curious about what tool(s) you used to do your analysis.

Did you look up the historical quotes and rebalance yourself or use a commercially available tool?

Do you know of a reasonably priced software package that would allow an individual investor to give it a go on his own?

posted about 1 year ago by Robert from Oregon

Thank you.

Nancy - I did think about including alternative investments, particularly the Permanent Fund, but doing so would have increased transaction costs, which I was purposely trying to limit. Plus, there is the problem of determining a proper allocation versus using an allocation strategy that is widely available to AAII members. Diversification does help a portfolio, and depending on what additional assets are included and how much of a weighting is assigned to them, performance should be improved.

Robert - I used Morningstar data, the same data published in our annual mutual fund guides, with an Excel spreadsheet. The advanced portfolio software seems only to be available at the professional level and, unfortunately, is priced accordingly.

-Charles

posted about 1 year ago by Charles Rotblut from Illinois

perfectly stated in the conclusion which i have cut & pasted
Both diversification and rebalancing are long-term strategies, and they should be treated as such. A common mistake that investors make is abandoning the strategies rather than sticking with them. Failing to stick with these strategies increases your portfolio’s exposure to the whims of the market, as the data in this article has shown.

There is no magical formula to building and preserving wealth. Rather, it requires patience, discipline and a sound portfolio strategy.

this is my 1st week in aaii & i want to get as much info as i can for the weekend to review. i have been a member of the motley fools since 12/28/8-08 so i am familiar with this type of thinking. thanks pat

posted about 1 year ago by Patrick from Wisconsin

Good article, but I have one question. Vanguard would suggest that your US stocks be 65% large cap, 27% mid cap, and 8% small cap.
You used 40%, 40%, and 20%.Why?

posted about 1 year ago by Philip from Illinois

The period covered by the study had unusually high bond returns. This is common in such studies of diversification because records are more easily available from more recent periods where there were more international funds were available, for example. I would be interested to see what happened when interest rates were going up instead of falling, and how much of the advantage was due to falling interest rates.

posted about 1 year ago by Jim from Michigan

Philip - Portfolio allocations ultimately need to be customized to one's situation and tolerance for risk. Over the long-term, small-cap stocks outperform large-cap stocks, which is why we give them a higher weighting than other models.

Jim - I still think you would find an advantage to rebalancing, even if a longer period was used. The reason is that your only alternative to diversification and rebalancing is to correctly predict when the best time to get in and out of an asset class is on a consistent basis.

posted about 1 year ago by Charles Rotblut from Illinois

It is my opinion that if you are assuming a 20+ year investment horizon, standard deviation or volatility is not very meaningful. So the optimal? Rebalanced Portfolio generated a final value of $847486 over the examined period. Pity the poor sucker who had not heard about these techniques of "diversification and rebalancing" and, if I understand the Static Portfolio correctly, had placed his $100000 totally and singly in the Vanguard Extended Market Index, VEXMX, a pretty wide diversification. He made NO changes over the time period and, in fact, had not even thought about his investment. He would have in his final statement $1,017,808, (4 X $254452), some $170322 MORE than his learned neighbor who diversified and rebalanced annually. Look at all the "fun" he missed!

posted about 1 year ago by HNM from Texas

How did you calculate Standard Deviation? In my spreadsheet, I get get totally different numbers/

posted about 1 year ago by Josephine from South Carolina

H - Standard deviation matters because it measures how volatile the portfolio was. This is very important because highly volatile returns can cause investors to sell at the worst time (e.g. December 2008). So while a single investment in VEXMX would have earned higher returns, many investors would not have been able to tolerate the roller coaster ride it experienced over the last decade.

Josephine - The formula I used in Excel was =STDEV()

posted about 1 year ago by Charles from Illinois

I think that the standard deviation for the Static Portfolio is considerably overstated at 27.1 I get 15.4 when I run the numbers and that seems more in line with the figures from the other two portfolios.

posted about 1 year ago by Gary from Illinois

In a 20+ year horizon, you are suggesting that volatility matters in say, the first 15 years? I do not agree. Volatility matters in the last several years prior to removing assets from the portfolio, in my opinion. Many investors may not be able to tolerate buying more of a fund when it has gone down for a year and selling a winning position in another even though that is what possibly should be done. It is my opinion that a young person with a ROTH IRA and a 20+ year horizon would not be smart to have anywhere near 30% of the IRA in a bond fund.

posted about 1 year ago by H from Texas

Gary,

You are correct. The standard deviation for the Static Portfolio is 15.4%, not 27.1% as originally published. The original calculation picked up a negative -100% return figure from a hidden cell, which resulted in the error. My apologies for the error.

Even after the correction, the static portfolio remains the most volatile of the three portfolios and shows the downside of not rebalancing on a regular basis.

-Charles

posted about 1 year ago by Charles Rotblut from Illinois

What formula did you use to get the Ammualized Returns? I see IRR was not used to determine the return on the investment.

posted about 1 year ago by Dan from Colorado

Charles,
Where do you find this data in Morningstar going back to 1988 and is this just year end price data with a % return for the year?

Would this data account for re-invested dividends? In general it seems to me that my Morningstar portfolios don't accurately account for re-invested dividends??

Thanks for a great article.

Dave

posted about 1 year ago by Dave from Washington

Dave - We receive a data feed from Morningstar with the fund information. Total returns are used, which include price appreciation and dividends. No cash was withdrawn from the portfolio.

posted about 1 year ago by Charles Rotblut from Illinois

Charles is to be commended for the effort and analysis he did for this article. However, because of the constraints he was trying to operate within (in particular, his attempt to match the Moderate Investor portfolio), he ended up constructing an “apples to oranges” comparison with the Static, Moderate, and Rebalanced portfolios that, at least in my mind, invalidate the results and the conclusions.

Why is it an “apples to oranges” comparison? The Static portfolio did not include VIMSX, NAESX, VEIEX, or VGSTX which were in the Moderate and Rebalanced portfolios. These funds all materially out-performed the mutual funds (in particular, VFINX and VBMFX) which were in the Static portfolio over the comparable years. You can see that by a casual comparison of the Static and Moderate portfolio spreadsheets in the article.

In simple terms, the Annual Returns of the Moderate and Rebalanced portfolios are primarily higher than the Static portfolio because of the addition of mutual funds which out-performed the funds in the Static portfolio.

Please note. I’m not trying to criticize Charles’ work. No doubt, he bent over backwards in order to present a reasonable comparison. I am merely offering a warning on the degree to which you accept the conclusions. It is difficult to construct an “apples to apples” comparison over the long term using several investment options, given the fact that historical data on most mutual funds (and different markets) is only readily available for the last 20+ years or it is expensive to acquire.

I have done my own back-testing of asset allocation and rebalancing. The common allocation that the big financial institutions describe in their literature and web sites is between the stock market, bond market, and money market. I tested 5 different allocations across those three markets. I tracked the results day-by-day to determine what the largest drawdowns were that an investor would have experienced. I compared the results for No Allocation, Allocation without Rebalancing, and Allocation with Rebalancing. What I found was that the best Annual Returns are achieved with No Allocation and that Allocation with and without Rebalancing produce about the same level of Annual Returns (for each of the 5 allocation methods). No Allocation produces the highest risk. Allocation without Rebalancing produces somewhat lower risk and Allocation with Rebalancing produces somewhat lower risk than that. (The results hold whether you reinvest dividends or not.)

I will acknowledge that over the long run, Rebalancing is somewhat better than not Rebalancing since it produces about the same level of returns with slightly less risk. (However, I don’t mean to imply that rebalancing is the best alternative for an investor.) However, an investor would have endured drawdowns of 22%-39% in his/her portfolio from time to time, depending on the level of allocation. If this is acceptable to you, then your investment expectations are lower than mine. I do recognize that each investor needs to determine an investment strategy that fits his/her “sweet spot” that balances off higher returns with lower risk, which are two conflicting goals.

I offer the following additional thoughts. (1) It is only implied in the article, but Rebalancing presumes you are reinvesting the dividends. If not, you should expect materially lower Annual Returns and seriously consider "No Allocation"(i.e. No Diversification). (2) In these days of very high correlation across all types of investments, asset allocation is not as effective. (3) As Warren Buffet is credited with saying, “Diversification [like allocation - JG] is for those people who don’t know what they are doing.” I would add, “Or for those people who just don’t want to spend time managing their money more than once a year.” (4) There is a large consensus in the investment community that higher risk produces higher returns. If the stock market didn’t produce higher returns to offset its higher risk, eventually everyone would catch on and stop investing in it. (5) When someone tells you about an investment that will allow you to make more money for less risk, you should inhale and count to 10 (3-4 times).

Jim Grant
Solon, Ohio
JWGrant@AOL.com

posted about 1 year ago by James from Ohio

Thanks James. I'm working on a follow-up article that provides a direct apples-to-apples between rebalancing and not rebalancing. It also factors in retirement withdrawals and long-term data on rebalancing. No set date for publication, but hopefully by the end of the year. I will be talking about it at our national conference in November, however. -Charles Rotblut

posted about 1 year ago by Charles from Illinois