Debunking Rebalancing Myths

February 3, 2017

Debunking Rebalancing Myths

  • The standard 60% stocks, 40% bonds allocation is extremely dangerous as bonds and stocks move together more often than not.
  • If something is overvalued, it doesn’t mean you should immediately invest in something that looks undervalued as it might just be less overvalued. If you think as a business owner  would, it’s easy to know whether an asset is over or under valued.
  • Yearly rebalancing has the same effect as quarterly rebalancing, therefore it’s more time effective.

The Usual Stocks, Bonds 60/40 Rebalancing

I hate when I see fixed rules in how a person should approach a portfolio, and find the 60/40 rule—that says you should hold 60% of your portfolio in stocks and 40% in bonds—the dumbest of all because there is no causality between stock and bond prices.

The investing 101 theory says that stocks do well in economic booms while bonds do well in recessions. However, the correlation between stocks and bonds has been very variegated in the past.


Figure 1: U.S. stock-bond correlation. Source: Reserve Bank of Australia.

Lately, the correlation between stocks and bonds has been positive which means that when stocks have gone up, bonds have too and vice versa. In the second part of 2016, bonds fell while stocks went up, but this is just short term noise.

What you can expect is that if interest rates increase, both bonds and stocks will fall so the standard 60/40 rule is a great way to make you feel protected but lose a lot in the end.

Other Ways To Rebalance

Apart from the 60/40 mistake, another mistake investors make is that they think they own stocks. You don’t own stocks, you own businesses and therefore rebalancing should be done by looking first at how your businesses are and will be doing. After taking a business owner’s perspective on your holdings, look at the price, i.e. the stock, and if something is overvalued and risky, you might want to trim that position.

In a typical rebalancing article, the above sentence would look like this: “you might want to trim that position and invest in XYZ…” This is another rebalancing myth as just because an asset appreciated while another depreciated, it doesn’t mean the second is now better. Remember to look at the business behind the security.


Figure 2: S&P 500 sector performance in the last 5-years (real estate is measured from October 2015). Source: Select Sector SPDRs.

As in each of the above sectors there are good and not so good businesses, the smart thing to do is to look for good or even wonderful businesses in a depressed industry. The industry needs to have positive future prospectives but negative current sentiment that results in lower stock prices but stable fundamentals.

A look at the distribution of PE ratios for 1,626 U.S. stocks shows that there are plenty of cheaper options to rebalance with.


Figure 3: Distribution of 1,626 U.S. stocks PE ratios. Source: quantfriend.

If a stock you’ve been holding has gone from a PE ratio of 12 to a PE ratio of 24 while the business remained the same, you might want to rebalance that position with a stock that has similar characteristics but with a PE ratio of 12. Thankfully, the stock universe gives plenty of opportunities to do so.

If you don’t feel comfortable buying something else, cash is also a great option as it gives you the opportunity to buy back the assets you’ve sold at lower prices later. You can read more about cash as an option here.

International Rebalancing

In yesterday’s article we talked about currencies and how to use currencies in your favor. Further, global markets have extreme differences, especially on fundamentals and growth. India has extremely positive future prospectives but stable, well performing companies can still be found at low valuations. GDP growth and development are going create much higher returns than what developed markets offer at the moment.

Gold & Rebalancing

Gold is considered the safe haven investment.

My favorite investment advice related to gold is the following: “sell when your taxi driver talks about investing in gold and buy when nobody wants to touch it with a 10-foot pole.” Such an approach to gold is what gives a large margin of safety and a huge upside.

How Often Should You Rebalance?

Rebalancing takes time as you have to assess your portfolio and come up with new weights. However, I have some good news for you. A Vanguard report found that there isn’t a big difference between quarterly and annual rebalancing strategies. Quarterly rebalancing sees more benefits come from volatility, while annual rebalancing sees more benefits come from the fact that you let your winners run for longer.

Conclusion

Many think a rebalancing strategy is set in stone, but this mindset is usually wrong. The set in stone part should be related to risk and reward. As soon an asset becomes too risky for the underlying return, you trim the position and hold cash until you find another asset or the same asset, now at a lower price, that satisfies your risk reward appetite.

Having a fixed asset allocation investment policy can be extremely dangerous as in today’s markets, risk reward patterns are very different to what you learned in Econ101. Bonds move together with stocks which means that they carry similar risks. Therefore, the only option is to analyze the risk and reward of each asset class in your portfolio and then rebalance in order to lower risks and increase returns.

Rebalancing is easy to write about and if rebalancing were that easy to execute, everyone would do it, but it isn’t and they don’t. But even small rebalancing activities can add a few percentage points to your yearly returns while lowering risk and a few percentage points make an extreme difference through an investing career.

By Sven Carlin Bonds Investiv Daily Rebalancing Risk Stocks Share: