For many planners, passive and strategic investment management is the way to go. As such planners often point out, the evidence is mixed at best that any money manager can ever consistently generate alpha by outperforming their appropriate benchmark. Accordingly, as those planners advocate, the best path is to minimize investment costs as much as possible (since we know expenses we don't pay is more money we keep in our pockets), and investment allocation changes should only occur via a regular rebalancing process. Yet rebalancing does not always improve your returns; sometimes, it actually reduces future wealth. So if you try to come up with a "passive" rebalancing strategy that only enhances returns and doesn't ever reduce them... does that mean you're actually being active after all?
The inspiration for today's blog post comes from an email correspondence I had with a financial planner following the recent New York Times article about my analysis of how critical the final accumulation years are for a retirement goal, and my follow-up blog piece about how portfolio volatility really impact financial planning goals. During our correspondence, the planner suggested that in fact, volatility can be a good thing, as even his completely passive strategic investment approach can be benefited through systematic dollar-cost-averaging of new savings and regular rebalancing when there is volatility. To which I replied: "If you're taking steps to create value by making investment changes in the midst of volatility, isn't that active management?" Yet the planner insisted that his process was purely passive, and not active. I respectfully disagree.
To understand why, it may be helpful to look at an example. The table below shows two investments, A and B. Investment A is a volatile stock fund that generates an average annual growth rate of 10% over the 5-year period; Investment B is a relatively steady bond fund that generates 5% returns. If I invest $100,000 in each and just let the money ride, the stock portion grows to $161,115, and the bond portion rises to $127,570; my total account is up to $288,685.
|Growth of $100k||$122,000||$103,700||$123,403||$125,871||$161,115|
|Growth of $100k||$103,000||$110,210||$114,618||$120,349||$127,570|
Of course, this includes no rebalancing! If we're going to include rebalancing at the end of each year - to "take advantage" of the volatility - we end out with very different results, as shown below.
|Growth of $100k||$122,000||$95,625||$128,520||$122,828||$159,532|
|Growth of $100k||$103,000||$120,375||$112,320||$126,441||$132,113|
Now, we end out with a total value of $159,532 + $132,113 = $291,645! With annual rebalancing, we created almost $3,000 of additional wealth, with a purely "passive" strategy. Isn't rebalancing great when there's volatility (as we see with the big stock decline in year 2)?
To be fair, it is true that the results here were improved by the volatility. For instance, if the stock and bond allocations generated the same 10% return in stocks and 5% return in bonds and we rebalanced every year, we'd end out with some very different results:
|Growth of $100k||$110,000||$118,250||$127,119||$136,653||$146,902|
|Growth of $100k||$105,000||$112,875||$121,341||$130,441||$140,224|
Without the volatility, our results actually got worse! Now our final combined wealth is only $287,126; rebalancing produced results that were below the rebalancing-with-volatility scenario. In fact, we actually finished with almost $1,500 less wealth than the first scenario, where we did no rebalancing at all! So not only is volatility good for rebalancing, but apparently rebalancing is actually "bad" without volatility?
Well, yes and no. It is true that at its core, rebalancing when investments only grow in a straight line actually does produce less wealth. For a very simple reason - if the investments both rise as a steady pace, simply with different returns, then all rebalancing does is systematically sell the higher return asset to buy more of the lower return asset; not surprisingly, then, if you consistently sell the investment that generates better returns for the one that generates inferior returns, you'll end out with less wealth, all else being equal.
But does that mean volatility is "good"? Well, not necessarily. At all, if we look back at the second example - rebalancing with volatility - where did the "value" actually come from? Why is it that the rebalancing with volatility resulted in higher returns, while the rebalancing with no volatility resulted in lower re
turns, compared to no rebalancing at all.
In reality, the rebalancing "worked" for one major reason: after year 1, we sold down the stocks that just had a 22% return, right before stocks well 15%, and bought a bunch of bonds that returns 7%. Then after year 2, we sold the bonds that had run up 7%, and bought more stocks right before they recovered by 19%! In other words, rebalancing worked because we... sold high, and bought low, and in the next year, we sold (something else) high, and bought (something else) low. Simply put, rebalancing with volatility works because it is a strategy that tries to buy low and sell high, as with any other active management strategy. Similarly, it doesn't "work" when there's no volatility, because now there are no buy-low-sell-high opportunities!
So does that mean volatility is actually a "good" thing? Well, I guess it is, as long as you're willing to try to actively buy low and sell high? Of course, you do have to get the timing right! Otherwise, you may get a scenario like this one:
|Growth of $100k||$122,000||$103,700||$127,276||$129,822||$157,835|
|Growth of $100k||$103,000||$110,210||$111,233||$116,795||$130,707|
In this final scenario, the client finishes with only $288,542, slightly less than the original no-rebalancing scenario. Yet in the chart above, there was still rebalancing! It's just that the rebalancing came every other year (i.e., after years 2 and 4), rather than annually. In this case, the client's rebalancing trades didn't occur in a manner that allowed him to sell the stock peaks to buy bonds, and then buy back stocks after the dip; instead, by buying every other year, the client ended out riding the stock returns up and down, and then rebalancing afterwards. In other words, if the timing of the rebalancing doesn't create actual instances of selling high and buying low, there's no value creation to rebalancing, even if the markets are volatile in the meantime.
The point here is not that therefore, you should rebalance every 1 year and not every 2 years. Their returns are just examples. They could have been annual returns, or quarterly returns, or monthly returns; the volatility could have been larger or smaller. The point is simply that in order for rebalancing to generate value, it has to re-create buy-low-and-sell-high opportunities, in the same manner as any other active management strategy. It is sells stocks to buy more bonds in the middle of a stock rally, it still loses; if it buys stocks in the midst of a multi-year decline, it hurts more than it helps. Only a sequence of rises and declines that create buy-low-and-sell-high opportunities allow rebalancing to succeed with volatility, and even then only when you get the "timing" right.
So what do you think? Is rebalancing a form of active management because it only "works" when you buy low and sell high? Does that mean we should spend more effort focusing on the timing of when to pull the trigger on rebalancing? And if we focus on the timing to rebalance, does that make us market timers? Or do you use a different definition for market timing?