The double-digit returns realized by the S&P 500 index would have been reason for a retiree to rebalance a diversified portfolio of equity and bond funds at the end of 2014.

An investor not taking withdrawals would have been able to leave his or her portfolio unchanged if the prompts to rebalance at the end of 2013 had been followed.

These are the finding of the latest update to my ongoing analysis on rebalancing. The analysis follows hypothetical portfolios based on the AAII’s moderate asset allocation model (www.aaii.com/asset-allocation). This model calls for allocating 20% to large-cap stocks, 20% to mid-cap stocks, 10% to small-cap stocks, 15% to international stocks, 5% to emerging market stocks and 30% to bonds. The portfolios are rebalanced annually when one (or more) of the allocations is off target by five percentage points or more.

Rather than rely on index returns, hypothetical portfolios with $100,000 starting values were created using Vanguard index funds to show the results an investor could have realized in a tax-favored account (e.g., a traditional IRA or a Roth IRA), excluding any transaction costs. The use of Vanguard funds restricted the starting date for the analysis to 1988, when full-year return data for some of the funds used was first available. This period includes three recessions, two bear markets (one that was extraordinarily severe) and two lengthy bull markets.

Two hypothetical portfolios were created. No withdrawals were taken out of the first one (the “non-withdrawal” portfolio). The second, the “withdrawal” portfolio, assumed a retiree cashed out 4% of his or her portfolio balance at the end of 1988 and then increased the withdrawal amount each year in accordance with the rate of inflation. The 4% inflation-adjusted withdrawal rate is the maximum amount that can be taken from a portfolio over a 30-year period with a high probability of not running out of money. It is based on research by William Bengen, with several other studies supporting his finding.

A more thorough explanation of the rebalancing process and why it might be an option for investors who find themselves unnerved by turbulent market conditions can be found in the May 2014 AAII Journal (“The Danger of Getting Out of Stocks During Bear Markets”). Spreadsheets showing full details of the updated data are linked here.

Higher Equity Allocation Gives Return Edge to No Rebalancing

An investor solely interested in maximizing wealth would have done better by not rebalancing over the 27-year period. This statement holds true regardless of whether or not portfolio withdrawals were taken. The non-withdrawal portfolio ended 2014 with $1.164 million under the rebalanced scenario and $1.218 million under the no-rebalancing scenario. The withdrawal portfolio ended 2014 with approximately $585,000 using the rebalanced scenario and approximately $650,000 with the no-rebalancing scenario. Table 1 shows the results for both portfolios, non-withdrawal and withdrawal.

Before dismissing rebalancing as a sub-optimal strategy, it is helpful to ask why no rebalancing resulted in greater ending wealth. There were two factors at play.

The first is the performance of the stock market. The Vanguard S&P 500 Index fund (VFINX) gained 32.1% in 2013 and 13.5% in 2014. The Vanguard Mid-Cap Index fund (VIMSX) also gained 35.0% in 2013 and 13.6% in 2014. Though the Vanguard Small-Cap Index fund (NAESX) had a more modest 7.3% gain last year, it soared by 37.6% in 2013.

Table 1. Performance of the Three Strategies

The second factor is allocations. When a portfolio is not rebalanced, its weighting to the asset class with the best long-term performance will increase over time. In the case of these portfolios, stocks have outperformed bonds. When rebalancing was not employed, the non-withdrawal portfolio ended 2014 with an 86.2% allocation to stocks and the withdrawal portfolio ended 2014 with an 87.2% allocation to stocks. When rebalancing was used, the two portfolios ended 2014 with equity allocations of 70.4% and 75.4%, respectively.

By not rebalancing, the allocation to equities was allowed to rise. In turn, the portfolio was better positioned to take advantage of the post-crisis bull market. The end result was greater wealth.

Notably, had the analysis ended on December 31, 2012, the results would have favored rebalancing. The rebalancing scenario resulted in 2012 ending values of approximately $908,000 and $468,000 for the non-withdrawal and withdrawal portfolios, respectively. In comparison, using the no-rebalancing scenario, the two portfolios ended 2012 with approximately $883,000 and $468,000, respectively. (The withdrawal portfolio was worth about $200 more under the rebalanced scenario than under the no-rebalancing scenario at the end of 2012).

It took the very good year of 2013 to give the no-rebalancing scenario the edge over rebalancing, and 2014 to widen the lead.

Are Higher Returns or Lower Volatility Preferable?

Given that rebalancing is a risk-reduction strategy, over longer periods of time, a strategy that increases exposure to risky assets (in this case, stocks), should perform better. The trade-off for pursuing greater long-term wealth is larger fluctuations in short-term wealth.

The volatility of the annual returns for the portfolios was greater under the no-rebalancing scenarios than under the rebalanced scenarios. The non-withdrawal portfolio experienced 29% greater volatility when no rebalancing was employed. The withdrawal portfolio experienced 14% greater volatility.

Investors are rewarded for taking short-term systematic (market) risk. The historical data shows this to be true. However, investing is part understanding the data and part being psychologically able to deal with the shorter variances that make up the favorable long-term returns. An investor who is able to maintain a long-term focus in the face of shorter-term, downward volatility may not need to rebalance. Conversely, an investor who is unnerved by downward market moves may find rebalancing to be a useful strategy. The reduction in volatility may help this investor achieve his or her long-term goals.

Where rebalancing may be particularly effective is in preventing panic selling. An investor who panicked and sold during the 2002 and the 2008 bear markets would not have regained the forfeited wealth even with the stock market’s good performance over the past two years. Rather, the behavior gap continued to loom large.

By getting out the market for just one year whenever the S&P 500 experienced a calendar-year decline of 20% or more, an investor’s portfolio would be more than $400,000 smaller than if he or she rebalanced, assuming no withdrawals were made. A retiree making withdrawals would have ended 2014 with a portfolio that was about $215,000 smaller than if he or she had rebalanced. For both portfolios, the investor would have ended 2014 with 33% less wealth than he or she would have had if rebalancing was utilized. This behavior gap is even larger when the panic scenario is compared against the no-rebalancing scenario.

The main point is that selling out of fear is extremely costly. Any step that can be taken to prevent panic-selling during a bear market, whether it is rebalancing or another strategy, can be beneficial.

A Change in the Data Used

A new source for inflation data was used as a part of this year’s analysis. The inflation data for adjusting the withdrawal rate was pulled from the St. Louis Federal Reserve’s FRED (Federal Reserve Economic Data) database (http://research.stlouisfed.org/fred2/). Specifically, the Consumer Price Index (CPI) for All Urban Consumers: All Items (CPIAUCSL). An average of the data from the first three quarters of 2014 was calculated to determine how much the end-of-year withdrawal rate for 2014 should be increased by relative to the 2013 withdrawal rate.

Previously, the inflation data was pulled from the Econstats website (www.econstats.com). This website no longer appears to be updated, though it is still contains considerable historical data. The inflation data used for adjusting the withdrawal rates for 1988 through 2013 is unchanged.

Retirees seeking data to determine how to adjust their withdrawal rates may want to consider using the FRED database. Though a lengthy discussion could be had on which statistic best measures inflation, it is more important to simply use data that gives a good approximation and is widely followed. The CPI provides a good estimation, despite its critics, of the rate of inflation and can be easily accessed via a variety of economic websites.

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