August 5, 2020 – In the 3+ years while working on the Safe Withdrawal Rate Series, I regularly get this question:
What’s my assumption for rebalancing the portfolio?
In the simulations throughout the entire series, I’ve always assumed that the investor rebalances the portfolio every month back to the target weights. And those target weights can be fixed, for example, 60% stocks and 40% bonds, or they can be moving targets like in a glidepath scenario (see Part 19 and Part 20).
In fact, assuming monthly rebalancing is the numerically most convenient assumption. I would never have to keep track of the various individual portfolio positions (stocks, bonds, cash, gold, etc.) over time, but only the aggregate portfolio value. If the portfolio is rebalanced back to the target weights every month I can simply track the portfolio value over time by applying the weighted asset return every month.
But there are some obstacles to rebalancing every single month:
- It’s might be too much work. Maybe not necessarily the trading itself but keeping track of the different accounts and calculating the aggregate stock and bond weights, potentially making adjustments for taxable accounts, tax-free and tax-deferred accounts, etc.
- It might involve transaction costs. Even in today’s world with zero commission trades for ETFs, you’d still have to bear the cost of the bid-ask spreads every time you trade.
- Even if you hold your assets in mutual funds (no explicit trading costs) there might be short-term trading restrictions prohibited you from selling and then buying (or vice versa) too frequently.
- It might be tax-inefficient. If an asset has appreciated too much you might have to sell more of it than your current retirement budget to bring the asset weight back to target. But that would mean you’ll have an unnecessarily high tax bill that year. Of course, this tax issue could be avoided by doing the rebalancing trades in the tax-advantaged accounts, not in the taxable brokerage accounts.
And finally and maybe most importantly, there might be a rationale for less-than-monthly rebalancing: it might have an impact on your Sequence of Return Risk. So, especially that last point piqued my interest because anything that might impact the safety of my withdrawal strategy is worth studying.
So, on the menu today are the following questions:
- Under what conditions will less-frequent rebalancing do better or worse than monthly rebalancing and why?
- How much of a difference would it make if we were to rebalance our portfolio less frequently?
- Could the “right” rebalance strategy solve or at least alleviate the Sequence Risk problem?
Let’s take a look…
Some preliminary calculations
Before we even look at actual historical stock and bond returns and I show a lot of fancy charts and tables with historical simulations, let’s first take a step back and try to understand the mechanics of how the rebalancing frequency will interact with our withdrawal strategy and under what circumstances it might help or hurt you to rebalance less frequently.
So, I built a tool to calculate and simulate portfolios with different rebalancing frequencies. So, I introduce to you…
… the Big ERN rebalance simulation Google Sheet
As always, when I post a Google Sheet, I cannot grant access for anyone to edit that clean spreadsheet online. Otherwise, people might mess with my formulas and ruin the sheet for everyone else. So, if you like to enter your own numbers, please save your own copy first! See below:
Each tab is for one simulation case study. The user inputs are in the top left corner of each tab. Here’s an example:
- The initial portfolio: $1,000,000
- The annual withdrawal percentage (but the actual withdrawals are monthly): 4%
- The stock allocation: 60%. This implies 40% bonds
- The rebalancing frequency: every 12 months.
- The first rebalancing event: after 12 months. Notice that separating these two parameters allows me to simulate a scenario where someone retires on September 30 but then does the rebalancing every year on December 31. In that case you’d set the frequency to 12 and the first rebalance at month 3.
- The retirement start date (month and year). In this case September 1929, right before the stock market peak. (not applicable in the case studies/ thought experiments involving “made up” return data)
- As always, all returns are in real, CPI-adjusted dollars and all withdrawals are adjusted for inflation as well!
Before we even jump into simulations with actual stock and bond market returns, let’s try to understand some of the rebalance mechanics at work and work through a sequence of scenarios with just some artificial return data.
I cooked up 5 different scenarios to distill the effects of the rebalance strategy:
Scenario 1: Constant Stock and Bond Returns
Let’s assume stock and bond returns are constant at 0.5% and 0.1%, respectively, every month (adjusted for inflation). So, there’s zero volatility and the average returns are roughly in line with historical long-term averages. Also, assume that the portfolio is not rebalanced at all (rebalance frequency = every 10,000 months = essentially never).
It turns out that there’s no impact on the portfolio, see below:
How is that possible? Without actively shifting around assets you can still bring the portfolio weights back through your monthly withdrawals, see the simulation results below. After applying the asset returns for one month, the stock portfolio weight has drifted to 60.10% in month 1. But if you withdraw mostly equities, around just under $3,000 and the remaining $377 in bonds you can bring the equity weight back to exactly 60%. So, you never have to reshuffle the portfolio beyond the monthly asset sales. You’d just have to make sure that the asset sales are not 60/40 but more tilted toward equities to adjust for the drift in the portfolio weights. More like 89/11 in this scenario.
Summary so far:
Lesson 1: The rebalance frequency is likely irrelevant with constant returns assuming that the Stock/Bond return difference is small enough relative to the withdrawal percentage.
Let’s look at another scenario…
Scenario 2: Return volatility with fast mean reversion
Since we need some return volatility to notice a difference across various rebalance strategies, let’s start with a simple volatile pattern: Stock/Bond returns are +5.0%, -0.5% in odd months, and -4%,+0.7% in even months.
Without actively rebalancing the portfolio, you’d do significantly worse than someone who rebalances monthly. About 0.34% after one year, growing to about 4% underperformance after 10 years, see the main results below:
Let’s look at how the portfolio positions look over time, see below. After the first +5% equity return, the equity portfolio weight goes up to 61.28%. Even if the entire withdrawal of $3,333 comes from the equity portfolio, you only manage to bring the equity share back to 61.16%. Indeed, if you wanted to rebalance this portfolio back to 60/40 you’d actually have to withdraw about $15,000 from equities, shift close to $12,000 back into bonds and withdraw the remaining $3,333. In any case, you now have a higher than target equity weight right before the -5% equity return strikes and this unlucky market timing explains why you underperform.
So, the retiree who rebalances less frequently (or not at all) is effectively a market timer now. But in the worst possible way; a high stock weight right before the next stock market decline and a relatively low stock portfolio weight right before the next big market rally, which explains the underperformance relative to a constant 60% equity weight, achieved through adjusting the weights at a monthly frequency.
Lesson 2: Rebalancing frequently helps you when returns “mean-revert” very quickly.
Let’s look at the next scenario…
Scenario 3: Positive equity momentum for the first 6 months
Let’s look at the opposite of fast mean-reversion: Momentum. Now imagine that the stock market outperforms for 6 months with 5% monthly returns and then jumps back to 0.5% again as in scenario 1. Wow, now you outperform when you don’t rebalance. Quite substantially:
What’s the reason for this result? Well, let’s look at the account balances over time, see below. After the first 5% return in month 1, the stock share has swelled to 61% again. As in scenario 2, even after withdrawing the entire $3,333 monthly retirement budget from equities, you’re still left with more than 60% post-withdrawal. So, if the good equity returns keep coming in the subsequent months, you’d be crazy if you took money out of equities and put into the low-return bond portfolio. If you face this positive momentum, why change the winning team? Let the strong returns run for as long as possible!
Thus the next main result:
Lesson 3: In light of positive momentum in equity returns, it’s best to balance less frequently
How about negative momentum? That’s the next scenario…
Scenario 4: Negative equity momentum for the first 6 months
Quite intriguingly, you also outperform when you face negative momentum. Assume that the equity market drops 5% every month for 6 months. Not rebalancing adds about 0.73% extra to your portfolio after one year, 0.96% after ten years.
And the reason is the same as before. Don’t try to go against the momentum. After the first month of bad, negative equity returns, don’t move money back into stocks when more bad news is in store for the market in subsequent months. Ride out the bear market and withdraw from the bond portfolio in the meantime.
Thus, the next result:
Lesson 4: The direction of the momentum doesn’t matter. In light of negative momentum, it’s still optimal to rebalance less frequently!
And onto one more scenario, combining the positive and negative momentum scenarios:
Scenario 5: A 6-month equity bear market followed by a 6-month bull market
Let’s combine scenarios 3 and 4 and build a bear market (6 months of -5% returns) followed by a recovery (6 months of +5% equity returns) and then back to scenario 1.
Uhm, well you actually do slightly worse. Without rebalancing, you’d lag behind about 0.1% after 1 year. How’s that possible? Well, you perfectly time the downtrend during the bear market and you have lower than 60% equity weight when the market goes down (about 52%). But the opposite effect is in place on the way up. When the market recovers, you still have less than 60% in stocks. So, you miss the bear market – that’s good! – but you also miss the bull market, which is too bad! The combined effect of the two is just about a wash.
The only way you could have “grabbed” the positive momentum in months 7-12 would have been to rebalance right at the bottom of the market after the last equity market drop.
Lesson 5: The market timing alpha from less-frequent rebalancing goes out of the window if you miss the turning point when the momentum direction changes!
In other words, the less frequent rebalancing works really well within one single updraft or one single downdraft of the market. Ideally, you want to rebalance once at the turning points (market peak and market bottom) to reset the portfolio and then benefit from the momentum in the opposite direction. Doing that at the right times will create a large outperformance relative to monthly rebalancing. But getting the timing wrong might also hurt you.
So: less frequent rebalancing is no free lunch. It relies quite a bit on skill (or luck) when timing the rebalance trades around the market turning points!
Simulations with actual stock and bond return data
What I’ve learned so far is that rebalancing at a frequency less than monthly could help you with Sequence Risk. That’s because the historical retirement cohorts negatively impacted by Sequence Risk started withdrawing funds right at the peak of the stock market and thus right at the beginning of a negative momentum phase for stocks (also known as a Bear Market!). You can ride out the negative momentum during the bear market! Thus, you avoid some of the “catching a falling knife” problem that you’d create with the monthly rebalancing.
The disadvantage of less frequent rebalancing is that if the market recovers quickly and you miss the rebalance at or around the bottom, then some or all of your rebalance alpha will go out of the window again.
So, could we save our butt with the “right” rebalancing strategy? Well, it wouldn’t be the first “solution” to the Sequence Risk problem that turned out to be a bit of a dud. But let’s take a closer look.
First, some case studies…
Case studies of a few prominent market peaks
For the simulations here I’m not relying on the Google Sheet I mentioned above. I built my own little simulation tool in Octave (the free version of Matlab) where I can quickly run simulations for thousands, even millions of cohorts really quickly all in one batch. (But if you like feel free to replicate some of the results with the Google Sheet.)
In any case, as a warm-up, let’s look at some of the retirement cohorts badly impacted by Sequence Risk:
- September 1929 (right before the Great Depression)
- December 1968 (the mid-to-late 60s were some of the worst impacted retirement cohorts on record)
- January 1973 (right before the 1970s economic malaise)
- September 2000 (around the dot-com market peak)
- October 2007 (global financial crisis)
Also, let’s assume we have a 60/40 portfolio and the following rebalancing frequencies: obviously the monthly baseline and the less frequent than monthly between every 2 months and 24 months, and finally also the scenario where we never rebalance (every 10,000 months).
So, I calculate the final portfolio value after 10 years under the different rebalancing assumptions and then compute the percentage advantage over the monthly rebalancing. I plot the results in the chart below. Uhm, that looks like a bit of a mixed bag! While the average is probably positive, there doesn’t seem to be a single rebalance frequency that helped you during every single event. This result shouldn’t come as a surprise given what we know about the rebalance mechanics: some or even all of the rebalance alpha might be lost due to missing the market bottom.
I also wanted to highlight one other issue. Remember from the setup of the Google Sheet above, there are actually two rebalance parameters: 1) the frequency and 2) the date of the first rebalance. For example, if retire in October and you like to do an annual rebalance, you don’t necessarily want to do the rebalance every year in October exactly on the anniversary of your retirement. Maybe you do it in December or around tax season in April. What kind of difference would that make in the five cohorts?
Let’s start with the quarterly rebalancing. Depending on whether the first rebalance occurs in month 1, 2 or 3 you get significantly different outcomes, see the chart below.
Let’s take the example of September 1929. The convention I follow in all of my simulations is that if you retire on September 1, 1929 then your first withdrawal occurs on August 31, 1929. If you pick the first rebalance month in month 1 (Mar/Jun/Sep/Dec rebalancing schedule) you generate a roughly 8% outperformance vis-a-vis the monthly rebalance. If you start rebalancing in month 2 (Jan/Apr/Jul/Oct rebalance schedule) then you lose about 7%. And if you rebalance in month 3 (Feb/May/Aug/Nov rebalancing) you gain 12% over the monthly rebalancing. This was actually the rebalance with the perfect timing because the market bottom occurs in month 33 during this bear market and thus rebalancing in months 3, 6, 9, and so on will perfectly grab that market bottom. Also, notice that the other 4 case study cohorts also have some great and some not so great outcomes depending on when you perform the first rebalance.
And we can do the same for the annual rebalancing. Now I plot the same chart as a function of the first rebalance (x=1,2, and all the way to 12), please see the chart below. Not surprisingly, due to the less frequent rebalancing, you have even more variation in results because there’s more room for messing up the rebalancing timing around the market bottom! In 1929 you’d have anything between a 7% underperformance (first rebalance in month 2) to an 18% outperformance (first rebalance in month 10). Market can be a blessing. Or a bi**h!
Simulation results using all cohorts
Let’s look again at the various rebalance frequencies between 2 and 24 months (plus “never” rebalance) and apply those to every single retirement cohort between 1871 and 2010. 2010 because the last cohort will need 10 years of return data to July 2020. All returns are in real, inflation-adjusted dollars and all withdrawals are adjusted for inflation as well. Then I simulate the first 10 years of withdrawals and compare the results and I compute the IRR of the first 10 years worth of portfolio values and cash flows, i.e., $1m initial investment and then 120 months of $3,333 and a final portfolio value in the last month. The stats for this exercise are below. Some results:
- Less frequent rebalancing will raise the average IRR. Quite intriguingly, the highest IRR prevails for the longest horizon (24 months), but there’s some deterioration when you go from every 24 months to no rebalances at all.
- You gain anywhere between 0.04% to 0.10% annualized. It doesn’t sound like much but keep in mind that this is purely free and lazy alpha. Considering that people make a fuss over 0.01% in the equity index fund expense ratios it’s nothing to sneeze at. For the average retiree with a $2m portfolio, we’re talking about $800-$2,000 p.a.
- Also quite intriguing: the share of cohorts benefiting from less frequent rebalances is above 70% for most of the frequencies. There’s clearly a benefit to letting the momentum run. Rebalancing too frequently would mess with your investment results!
As always, of course, looking only at the unconditional results might not be that informative. It could be that the rebalance strategy helps you mostly when the portfolio is going through the roof anyway. To be a hedge against Sequence Risk, we’d need to see good performance in light of low returns. So, I computed the same results again, but only for the 10% worst performing retirement cohorts (i.e., the lowest decile IRR for the baseline monthly rebalancing). The results are in the table below.
- Well, the average outperformance is now down to essentially zero. For the 24-month and “never” rebalancing strategies you even underperform pretty consistently, both when expressed as the mean but also the distribution; only 28.57% and 6.55% probability, respectively, of outperforming the baseline.
- But I’m positively surprised about how well the 3-month all the way to 6-month frequencies held up. They all still display a slight average advantage over the baseline and outperformed with 50+ and even 60+% probability over the simulations. Not bad!
What’s the net-net? If you have to pin down a desired rebalance frequency, I’d probably advise against an annual frequency due to the 60%+ probability of underperformance in the lowest decile. Instead, I’d probably go with a 3-month rebalance frequency. That seems to give you some outperformance during all market environments but, crucially, also performs well for all the unlucky cohorts during 10% worst market environments during the first 10 years of retirement. But again, always keep in mind that this is not a guaranteed alpha. There have been cases where the less than monthly rebalancing will backfire.
Conclusions
Ideally, you’d want to rebalance only exactly twice during the course of a full market cycle: once at the top of the bull market and once at the bottom of the bear market. And in between simply ride the momentum up and down. But market timing is not something that the average retiree wants to worry about.
Not rebalancing monthly might deliver some slight advantages over my monthly rebalancing assumption. That’s actually really good news for my Safe Withdrawal Rate Series because it means that the monthly rebalance assumption is a bit on the conservative side and actual retirees in the field don’t have to worry that maintaining their portfolio weights less frequently will blow up their retirement safety. Quite the opposite, by being a bit sloppy and lazy and adjusting the weights maybe only every quarter you might do just a little bit better on average.
Would I call this a “solution” to sequence risk, though? Absolutely not. The “timing alpha” inherent in the less-frequent rebalancing is not that consistent. It’s more of a hit-or-miss with a slightly positive mean over time but also some downside risk. By getting the timing of the rebalancing around the turning points wrong just by a month or two you could do worse than with the monthly rebalancing.
Thanks for stopping by today! Please leave your comments and suggestions below! Also, make sure you check out the other parts of the series, see here for a guide to the different parts so far!
Picture Credit: pixabay.com
Great post as always ERN. Thanks and keep them coming.
Annual rebalancing is generally the minimum here in the U.K. in order to take advantage of capital gains tax allowance (currently £12,300 pa) and also to shift funds into a tax favoured account (£20,000 pa).
I also carry out a review every six months and rebalance if required.
Nice! Thanks for sharing!
That’s one issue I hadn’t considered. If you have an annual allowance for cap gains, yes, then you should rebalance and “tax gain harvest” at least once a year.
Personally I like to keep track of my investments so I always have a good view of my portfolio balance. My strategy is to rebalance when the difference is more that 10% (eg 60/40 becomes 70/30)
Yes, that’s a good point. And in the times of PersonalCapital and other tools it’s pretty easy!
Actually, 10% mistracking is quite substantial. That would potentially be only every few years.
This was a great analysis, thank you! I’d be interested in whether a rebalancing strategy based on deviation from target (as suggested by DutchFireGuy) rather than time (i.e., monthly vs quarterly vs annually) would be better or worse in the different scenarios above. And how would a rebalancing when out of balance by 1% regardless of timeframe compare to rebalancing when out of balance by 2% or 5% or 10%, etc.
Yeah, good point. I may do a follow-up on that. Good point about the endogenous rebalance depending on the distance to target.
I would be very interested in this as well. Rebalancing more often has the intuitive advantage of putting a “buy low, sell high” approach into practice (eg., when stock allocation increases due to market ebullience, you sell a bit and reallocate to cash+fixed income). There is a market timing component implied though and it would be good to see if the whiplash associated with very frequent reallocations (eg, every time distance is more than 1% from target) negates the benefit of a disciplined approach to asset allocation.
Very true. This evolves into market timing very quickly and sometimes it works and sometimes it backfires.
OK, next thing to check, is there an ideal formula for rebalance frequency verses cape (ie cape high -> rebalance every 3 months, cape low -> every 2 years)
I also would love to see if Karsten has any thoughts on cape-based shifts in asset allocation. For a few years I have been using a cape based strategy in which I shift my asset allocation from 70/30 stocks/bonds to 60/40 whenever the cape goes above 30, but if the cape drops below 25 I shift back to 70/30 and I keep it there until it hits 30 again. I don’t have to make frequent shifts in my asset allocation because I have the 5 point cape score buffer and I often go several years with no change to my asset allocation.
However, this year has been unusually volatile and I have already made two allocations shits.
I started off the year at 60/40 and then shifted to 70/30 in March but by June I was back to 60/40 where I remain today.
This strategy seemed to work pretty well this year, but I am not sure if it makes much difference in the long run.
By the way, I don’t have a set schedule for rebalancing but I would estimate I do it a handful of times per year. I use Personal Capital to track my portfolio, so I can always see at a glance what my percentages are.
Interesting idea. I have played around with a double CAPE rule: CAPE determines the WR and also the asset weights. It’s on my to-do list! 🙂
Awesome!
I had a note to myself written long ago in my notes to see if you revisited this! Please so!
Ah, it’s still on my to-do list. Working on it! 🙂
Ah, yes, that was one thing I didn’t include. Might have to write an update! 🙂
Rebalancing based on a calendar doesn’t really resonate with me. Doesn’t it make more sense to rebalance when your desired asset allocation drifts by a certain amount, like 5 or 10%?
This is also my question and more to my intuition. But maybe harder to compute?
Not really harder to compute. Stay tuned for an update. 🙂
Yes, definitely! I’m working on an update with an endogenous rebalance rule, i.e., if the target weights are off by x% and then x=1%, 2%, 5%, 10%. Very valid point!
Hi ERN
What does this look like if you don’t rebalance time-based, but “portfolio-based”, ie. once you shift away from the desired allocation by a certain percentage or even by a raw amount? This may automatically “skip” market events with quick mean reversion AND let you “ride” (some) momentum based markets?
Haha, as I just mentioned in the other comment: it’s on my to-do list. That’s a very valid rebalance rule. Should write an update! 🙂
Is there a strong correlation between optimal rebalancing date and the Vix? Maybe the higher the Vix is trending the smaller the rebalancing interval?
Interesting idea.
2 problems with this: 1: VIX data starts in 1990, I believe. 2: with a high VIX *level* you might still hold off with the trades, as this often signals negative momentum. I think the timing mechanism would be high VIX but starting to top off and decline again.
But it’s an interesting idea. In the end it all boils down to market timing again! 🙂
Nice! How does rebalancing on bands (say being 5% off target allocation) work?
Yeah, I like the band/guardrail idea. Might have to write an update on this! 🙂
nice post, thx. how about using a momentum signal to inform the rebalance?
Nice idea. I’d have to look into that. I hope I can do an update on this post! 🙂
How would you reconcile this against glide paths, which are done monthly? Really interesting post. You always make me think just a bit more!
A GP is a different strategy. It has the same feature in that it avoids selling equities and rather sells bonds to fund current expenses during the bear market.
The main difference: the GP actually shifts money from bonds into stocks regularly. The timing would be off a little bit at the beginning of the bear market (that hurts you). But you’d nicely rebalance from bonds into stocks right around the bottom of the bear market. You get better timing of the market bottom with a GP.
Maybe one should,combine the GP with the infrequent rebalancing. Hmmm, have to think about that. This might require a follow-up. 🙂
Phenomenal post. This makes me wonder about Target Date Funds (most of which rebalance daily) . . . on the one hand, they’d hit every major market turn (both peaks and valleys), yet they’d never be able to ride the momentum.
Not sure if they rebalance the weights daily. Depends on a the fund. At my former workplace we used to manage one fund that had only quarterly rebalances.
ERN,
As usual, a very thought provoking post. I truly enjoy reading your posts and all of the work that goes into them. You are our grand master. I am curious aout two things:
1. does the conclusion change if the 60/40 portfolio allocation moves to 70/30 or 50/50?
2. as others have posited, rather than a time based rebalance, how about a “guardrail” rebalance (something like rebalance only if the allocation deviates by x%? And then the obvious question, what is x%?
All goos questions. I also ran this with 50/50 and 75/25 and the results were qualitatively the same. The more concentrated the weights are, the less rebalance alpha you can expect. So, the variation of the rebalance alpha was less with 75/25 and more with 50/50.
And yes, I should write more on the guardrail approach. Maybe a new post in the future… 🙂
Definitely want to chime in on seeing a run using 5% from target re-balancing. I think that is what a significant number of DIY retirement investors do. Thanks – love the series!
Yes to this!
Yup, will write someting on that topic! 🙂
Hi Karsten, excellent analysis as always! In addition to asking for the optimal rebalancing frequency I want to raise the question if rebalancing is beneficial at all in the context of SoRR management. Alternatively we could also withdraw according to our asset allocation.
Example: monthly withdrawals are 5.000 USD and we start with a 60/40 equities/bonds allocation. According to this asset allocation we would withdraw 3.000 USD from equities and 2.000 USD from bonds.
Now let’s assume that a few years later the portfolio allocation changed to 80/20 due to higher equities returns. The 5.000 total withdrawal would then comprise of 4.000 equities and 1.000 bonds according to the new asset allocation.
This also works as some sort of glide path since the equities allocation should increase over time due to higher expected returns. And increasing the equities allocation after starting the withdrawals is beneficial as you also demonstrate in your SWR series.
I simulated this approach with a 60/40 equities/gold portfolio here: https://www.finanzen-erklaert.de/die-4-regel-war-gestern-kommt-jetzt-die-55-regel/
The article is unfortunately in german but the embedded charts speak for themselves. The above mentioned approach allows for significant higher withdrawals compared to a static asset allocation. I didn’t try a 60/40 equities/bonds allocation, but I wouldn’t be surprised if we would see superior results as well.
Cheers, Georg
I caution against using those results. I’ve written extensively on glidepaths (Part 19/20) and pointed out the advantages. But the advantage does not make a difference 1.5 percentage points in the WR. Much smaller.
The post you mention starts simulations only in 1975 and thus misses all the bad retirement cohorts (1929, 1965-1968, 1973).
Sure, pls ignore the absolute results. They are certainly driven by the data selected. I didn’t want to use gold prices before 1975 due to Breton Woods and a therefore deteriorated price mechanism.
The thing I wanted to highlight is the technique of depleting your portfolio in line with your asset allocations. Looks like this produces superior results over rebalancing regardless the asset combination and time series used. So maybe we shouldn’t rebalance at all?
I haven’t simulated that yet, but my suspicion is that the two alternative methods make that much of a difference. You withdraw only $3333 per month, so whether you use the 60/40 on the withdrawals or use the withdrawals to do a partial rebalance wouldn’t make that much of a difference over time.
Lieber Karsten,
thank you very much for your show.
In these days and age, government bonds don’t seem like a good idea for the next few years or even a decade? How about almost 100% stocks plus a corresponding cash buffer?
(Aren’t you following a kind of 50stocks/30stockoptions/10property/5cash scheme?)
Have you ever tested how a cash buffer for the first 5-7 years only would have affected a withdrawal strategy?
For example, 5/10/15% cash at the start of the withdrawal, then reduction only in bear markets (e.g. the price of world portfolio is below SMA200) without replenishing?
What would have been the optimal start cash amount in the past? Which low SWR would it have meant in the worst phases of history?
Or have these questions already been discussed in another blog post?
Many thanks in advance
Joerg
Hallo lieber Joerg!
Yes. Please see parts 24 nd 25 of the series. 🙂
Viele Gruesse zurueck nach D!
There are two most relevant papers on this topic, showing more systematic approaches with significant advantages over rebalancing with fixed time periods.
“Opportunistic Rebalancing: A New Paradigm for Wealth Managers” by Gobind Daryanan shows that relative rebalancing only those assets, which deviate +/-20% from target allocations, similar to the well known 5/25% Swedroe rule, can minimize transactions and maximize rebalancing alpha surplus returns significantly overall.
http://www.smgfa.com/resources/Opportunistic_Rebalancing_JFP2007_Daryanani.pdf
“Strategic Rebalancing” by Campbell R. Harvey et al points out that regular rebalancing monthly or quarterly even increased draw downs in severe crises. This risk can be reduced significantly by “strategic rebalancing, which uses smart rebalancing timing based on trend-following signals”.
http://www.man.com/strategic-rebalancing
For me this rebalancing approach combined with the Swedroe 5/25% rule and applied to 50/50 pure indexing and trend following managed futures is currently among the best antifragile approaches for long-term investments during any market regime to come from boom to most severe bust of 1929 ff and an endless ww Japanese scenario.
Wow, nice papers. Thanks for the links! You’re the best!
Hi Norbert,
Thanks for the article link. Very valuable. I will incorporate CAPE and may be with a sprinkle of VIX for re-balancing. At least I know for sure that doing regular re-balancing on particular day is simply wrong.
Karsten – This is probably the first article that I know that you got a assignment from. You/Your blog has fundamentally changed for the better my way of managing my portfolio for that I am truly and unequivocally thankful.
I for once can’t congratulate you because after reading all this I am still not sure if it’s quarterly or monthly or what’s the ideal interval. Please give me a number !
Every 3 months.
Haha, yeah, thanks for creating more work for me. 🙂
I for once can’t congratulate you because after reading all of this I couldn’t grasp what’s the ideal re-balancing interval. I’d says it’s quarterly but that’s not clear at all on the text
Huh? I thought I somewhat endorsed the 3-month rebalance frequency!?
Sorry, just saw it now above. Many thank you for clarifying.
Great job you do but sometimes it’s too much math for me
Very insightful post!! I hope you will find the below post useful.
https://fundamentalmarket.wordpress.com/2020/08/17/weekly-market-newsletter-2/
This is the first time I’ve wandered in here.
May I summarize your recommended approach as follows?
100% equity, no cash required.
(SP500 Index)
Withdrawal rate is about 3.25-3.5%.
(Fixing it at 4% is dangerous.)
We can’t rely on dividend yield defenses.
I don’t reocommend 100% equities. Too much Sequence Risk. There have been times when that much equity exposure would have pushed the fail-safe to well below 3%.
I’m sorry about that.
So what percentage are you recommending?
Which article is on it?
It has to be tied to your personal situation. Depends on how much other cash flows you have. Likely 60-75% equities would be optimal for most folks.
I have a Google Sheet (Part 28) where you can fill in your parameters and play around yourself. 🙂
I recently retired at 50. Rebalancing non retirement accounts impacts my MAGI. Since we use Obamacare (US), we have to watch our MAGI closely. We have always been in accumulation mode, so this is new territory for us. Rebalancing more often could negatively impact our annual target, causing us to overshoot our target. I have rebalanced twice so far this year and didn’t really consider this interval too much. I’m looking forward to further analysis based on percentage change as well.
Good point. Money is fungible. If you do want to rebalance monthly and your retirement accounts are large enough you should be able to do so in your retirement accounts ONLY, without messing with your MAGI.
Thank you for the insightful article. I am also in this Obamacare situation and need to rebalance from 70/30 to 65/40. The only investments in our retirement accounts our International stocks. If I sell the required amount of international stocks (VTIAX) to buy international bonds (VTABX) it will put us in balance in our overall portfolio. Do I need to worry about not being in balance on the International side?
If you can’t do the rebalance in a tax-advantaged account you may as well keep the current allocation. The tax impact would be prohibitively expensive.
I use the CAPE ratio as a rough gauge of my target asset allocation while in the accumulation phase, using AA = 30 / cape10. I feel comfortable using some margin when stocks are “cheap” and pay off the margin loan when they are “expensive”. For example, at the current cape ratio of 35.8, I’d target an 84% stock allocation, but last March when the cape ratio got down to 22ish, I targeted 136% in stocks. I never actually sell stocks when they are higher than my target just instead just choose not to reinvest dividends and pay off the margin loan with new contributions until they are “cheap” again. I haven’t done any long-term backtesting on this strategy but its worked pretty well over the past few years. If we ever had a repeat of 2008 with the CAPE ratio got down to 15ish, I would have about 2x leverage which is fairly risky but I’m comfortable with it for now. Obviously a Great Depression type (90%+ decline) event would cause a ruinous margin call but I think today’s government/federal reserve is pretty committed to spending its way out of catastrophes to make sure stocks don’t decline by more than 60%+ again in my lifetime at least.
Wow, that’s aggressive. I would probably pick a less aggressive numerator, maybe 25/CAPE. But I like the idea, That’s something that’s worth investigating with some simulation. Then you’re at less than 100% stocks, where would you invest the rest? Money Market? US Treausry? Agg Bond Market?
I apologize if this is already written about. A question around rebalancing and glidepath. If you are following a Prime Harvesting methodology and letting your stocks to bonds allocation drift – would you still regularly rebalance your diversification on a regular monthly interval? Seems like their might be some good momentum benefits of giving those sub asset classes some time
It’s a two-edged sword. As I wrote in the post: momentum helps you but if you just catch the bottom of the market and then rebalance it will hurt you.
Big ERN,
Did you ever update this rebalancing study based on portfolio performance and not time?
Not yet, but I plan to do that in the context of studying bucket strategies. Don’t get your hope too high, though. Tactical asset allocation models run by retail investors will not reliably beat the market. It’s hit-or-miss, just like the N-month rebalancing here.
Gotcha. Thx for responding and will stay tuned!