Wednesday, April 7, 2010

Missing the Benefits of Asset Allocation

One of the benefits of maintaining a constant asset allocation is that it forces the investor to buy low and sell high. However, this only works if investors actually do the rebalancing when the asset mix is off.

In a few places now I’ve seen comments from an investor who failed to rebalance during the lowest stock prices a year ago, but that “this is okay because my allocation percentages have almost come back in line.” Unfortunately, this investor has missed the opportunity to profit from rebalancing during the period when stocks went on sale.

To illustrate what I mean, let’s consider an example. As of the first trading day in July 2008, two investors, Adam and Beth each had $100,000 in bonds and $100,000 in the Canadian large-cap index exchange-traded fund XIU. Their intent was to maintain this 50/50 split.

However, Adam didn’t do any rebalancing, preferring to think about anything else other than falling stock values. On the other hand, Beth checked prices on the first trading day each week and rebalanced if the allocation got further out of kilter than 55/45.

Let’s compare their results. To simplify the comparison, we’ll assume that the bonds remained flat and ignore the XIU dividends. The idea is to just see what effect the rebalancing would have.

Adam just rode XIU up and down throughout this volatile period from a starting price of $19.94 per unit to $17.88 per unit.

Adam’s portfolio today:

Bonds: $100,000
XIU: $89,700
Total: $189,700

Beth rebalanced three times:

2008 Sep. 29: Bought $10,900 XIU at $15.59
2008 Nov. 17: Bought $10,500 XIU at $11.90
2009 May 4: Sold $11,000 XIU at $15.23

Beth’s Portfolio today:

Bonds: $89,500
XIU: $105,100
Total: $194,600

Trading just 3 days over nearly 2 years, Beth has come out ahead of Adam by about $4900 using a purely mechanical system requiring no judgement. This is more than enough to cover trading costs. Even if the savings were in taxable accounts, Beth would come out ahead.

Some investors choose not to rebalance ever, and this can be a reasonable approach. However, having a rebalancing strategy, but abandoning it when “things look scary” is just another form of following the crowd.


  1. “this is okay because my allocation percentages have almost come back in line.”

    The absurd part is not that he missed his chances to profit, but he obviously doesn't have the slightest idea why he is diversifying holdings via asset allocation.

    Just one more example of how professional planners sell products to earn commissions, then ignore the customer.

  2. Great analysis Michael. I'm sure that more than a few people abandoned their strategy during the crash. Perhaps that's a sign that their asset allocation wasn't right in the first place.

    Not following your plan is a sign that you don't trust it, and that it might need some changes. If you are more risk averse than you thought when you filled out those forms, maybe it's time to lower your equity allocation and resolve to rebalance the next time we hit an air pocket.

  3. Mark: I agree that few investors understand the theories behind asset allocation.

    Balance Junkie: Ironically, many investors who convince themselves that their allocation was wrong are really just following the crowd. During the crash they saw the light and adjusted their allocation to stocks down. In a few years many such investors will decide that their stock allocation should be higher. This is just a smart-sounding way to follow the crowd. I can respect people who waited out the crash and then decided to change their allocations, but those who sold stocks during the crash thinking this was a change in allocation are largely fooling themselves.

    CC: Agreed.

  4. Michael, how often do you recommend rebalancing? I currently do it once a year, in October. Do you think that's often enough? Also, October is entirely arbitrary. My "rationale" is that I don't want to rebalance with the crowd in January so I figured I'd try October (end of Q3) but really I'm uncertain about this. I'm 33 years old with an investment horizon of (god willing!) about 25-30 years. Thanks!

  5. Doug: I can't say what is best for everyone, but some guidelines are keeping trading costs to a minimum and sticking to a plan. If you normally rebalance once per year in a particular month, but don't one year because things look scary, then you're changing your plan midstream and are following the crowd to some degree.

  6. Ice cream on a stickApril 9, 2010 at 1:01 PM

    Sticking with a plan – 100% agree.
    Rebalancing – I am not sure. It’s a matter for discussion.

    Statistically speaking, rebalancing is pointless in many situations. When both asset classes go down, and, of course, one falls faster than another, you would be selling one of the components low to invest in something even lower, which plummets much faster. In fact, the probability of successful rebalancing appears to be the same as a not successful one. What if you sell something high and it went even higher, and bought something low, which kept going down? You never know.

    In my opinion, the best way to “rebalance” is to invest new money in the asset class, which is cheaper at the moment. The asset allocation will be a little off, but your original asset allocation percentage is arbitrarily established anyway, isn’t it?

  7. Ice cream: Everyone has ideas of how to choose and maintain their allocations. I just think it's important to avoid changing midstream to follow the herd.