415 Chapter 10 Rebalance Or Buy Low Sell High

In today’s podcast, we are going to explore Rebalancing. We will look at investment portfolio construction, how rebalancing is implemented and when you should consider doing the rebalancing. When you are getting ready to retire you will begin to think more about how your investments can generate the cash flow and you will likely feel the need to reduce volatility when you begin taking portfolio withdrawals. Rebalancing serves primarily as a risk mitigation tool rather than a means of maximizing returns. According to a paper by Vanguard, “rebalancing tends to increase a portfolio’s Sharpe ratio, improving risk-adjusted returns”.

Retirement Calculator – How Much Money Do I need To Retire?

Articles, Links & Resources:

Vanguard: Getting Back On Track – A guide to smart rebalancing

Morningstar: 5 Ways Rebalancing Can Benefit Your Retirement Plan

Retirement Researcher: How Often Should I Rebalance My Portfolio

Michael Kitces: Finding The Optimal Rebalancing Frequency.  Time Horizons Vs. Tolerance Bands

Transcript:

Announcer: [00:00:00] Welcome back America to Sound Retirement Radio, where we bring you concepts, ideas, and strategies designed to help you achieve clarity, confidence, and freedom as you prepare for and transition through retirement. And now here is your host, Jason Parker.

Jason Parker: America, welcome back to another round of Sound Retirement Radio.

I’m so glad to have you tune in into this episode. You’re listening to episode number 415, chapter 10, rebalancing. Or, buy low, sell high. Before we get the day started, I like to renew our mind, and I’ve got a verse here for us from Colossians chapter three, verse 12. Therefore, as God’s chosen people, holy and dearly loved, clothe yourselves with compassion, kindness, humility, gentleness, and patience.

And then something fun for the grandkids. Why did the ghost starch his sheet? He wanted everyone scared stiff. What do you call a running turkey? [00:01:00] Fast food. All right. Be sure to visit soundretirementplanning. com and click on episode number 415 for articles, links, and resources mentioned in today’s show.

In today’s podcast, we’re going to explore rebalancing. We’ll look at investment portfolio construction, how rebalancing is implemented, and when you should consider doing the rebalancing. When you’re getting ready to retire, you’re going to want to begin thinking more about how your investments can generate cashflow, and you will also likely feel the need to reduce volatility when you do.

You begin taking portfolio withdrawals. Rebalancing serves primarily as a risk mitigation tool rather than a means of maximizing returns. According to a paper by Vanguard, rebalancing tends to increase a portfolio’s Sharpe ratio, improving risk adjusted returns. Next week, you’re going to want to tune back in because we’re going to cover chapter 11 where I do a deep dive into Medicare.

Without any further ado, here is chapter 10 [00:02:00] rebalance or buy low, sell high. A sailor navigating stormy seas is analogous to a trader in the financial market. You may have heard the saying, a pessimist complains about the wind. The optimist expects it to change and the realist adjusts the sales. When it comes to investing, adjusting the sales is what I call rebalancing.

Before we take a more in depth look at rebalancing, we will look at stock performance. Everyone wants to buy a stock at a low price and sell it at a high price. However, a research paper by J. P. Morgan Asset Management titled The Agony and Ecstasy Published in 2014, looked at the risks and the rewards of concentrated stock positions compared with the performance of the overall Russell 3000 Index from the year 1980 through 2014.

The Russell 3000 Index measures the performance of the largest 3, 000 U. S. companies representing approximately 98 [00:03:00] percent of the investable U. S. equity market. It’s reconstituted annually to ensure that new and growing companies are reflected. The researchers analyzed all the stocks that were part of the Russell 3000 Index from 1980 to 2014, which included a database of 13,000 large, mid and small cap stocks.

And there were a few important takeaways that are summarized in the executive summary of this report. Some companies substantially outperform their broad market and maintain their value. However, the odds have been stacked against the average concentrated holder. According to the Agony and the Ecstasy article, the risk of permanent impairment using the universe of Russell 3000 companies since 1980 shows roughly 40 percent of all stocks have suffered a permanent 70 percent decline from their peak value.

It also states 40 percent of stocks experience negative lifetime [00:04:00] returns versus the broad market. The return on the median stocks since its inception versus an investment in the Russell 3000 Index was negative 54%. Two thirds of all stocks underperformed the Russell 3000 Index. And for 40 percent of all stocks, their absolute returns were negative.

This paper states that since 1980, over 320 companies were deleted from the S& P 500 for business distress reasons. We think that it’s almost un American for a company to go out of business, but the reality is that companies go out of business all the time. According to the website Statista, The average lifespan of a company on the S& P 500 index is only 21 years.

This is true even for the big companies, the strong companies, the companies that are big enough to make it into an index like the Russell 3000 or the S& P 500 index. Jack Bogle, the founder of Vanguard is quoted as saying, don’t look for the needle in the haystack, just buy the haystack. This J. P. Morgan [00:05:00] study reveals that 40 percent of companies suffered a permanent decline of 70%, and two thirds of companies do not perform as well as the index, and only 7 percent of the companies outperformed the index averages.

You can see how stock picking is like trying to find the needle in the haystack. This study shows you that stock picking comes with a high degree of risk and that there are few reasons to believe it will work. Diversification can help you achieve the returns you need without taking on significant risks.

Instead of attempting to discover the next big winning stock, you can benefit from diversification by investing in a low cost index fund. Trying to be the next Warren Buffett with stock picking may be fun when you’re accumulating wealth and you don’t need to depend on the resources. But if you’re getting ready to transition into retirement, consider using low cost index funds to create broad diversification across asset classes, sectors, and to be diversified across the entire globe.

Investment portfolio [00:06:00] construction. Portfolio construction means that you’re going to need to make some decisions about how to allocate your investments across several different dimensions. How much will you have in domestic stock versus international? Will you include emerging markets? How will you allocate between value and growth?

Will you overweight technology or consumer staples? Or how about companies that pay dividends versus companies that don’t? What type of fixed income will you include? What about high yield? How about the duration of those bond holdings? What will you be comfortable with? Will you include fixed income alternatives such as certificates of deposit or fixed deferred annuity contracts or savings accounts?

How will you diversify across taxable, tax deferred, and tax free positions? You can use index funds to make the asset allocation decisions, but at some point, the rubber will hit the road and you will have to decide on how you’re going to construct a portfolio. Just like taking concentrated stock positions is hard to justify, it’s also hard to [00:07:00] justify taking concentrated asset allocation decisions when you can easily enjoy broad, global diversification.

Often, people will look at the historical performance of an asset class and try to understand the risks associated with the asset allocation mix, and then construct an investment portfolio that will have the qualities, characteristics, risks, and benefits. Risk profile and performance that is needed to make sure that you’re going to be okay in retirement.

What is rebalancing and how is it implemented? The idea of rebalancing is to maintain asset allocation over time. If you don’t rebalance, then the investments that perform better tend to overtake all of that. all your asset allocation strategies. For example, let’s say in 1990, you decided to invest 60 percent in stocks and 40 percent in bonds because you were comfortable with the risk reward of this type of asset allocation, if you never rebalanced from 1990 to 2020, then your stock allocation would have grown from 60 percent to 81 percent by the [00:08:00] year 2020 and the bonds would only represent about 19%.

Typically, you have the bonds in the portfolio for that ballast for stability. You’re not trying to earn a lot of money as it is. You’re just trying to remove some of the risks of the stock segment of your portfolio. Now 30 years later, you would have much more exposure to stocks than you had originally decided upon, which historically has meant being more aggressive and taking on more risk and accepting higher volatility.

Rebalancing is the process of realigning the weightings of the portfolio assets. For example, if the original asset mix was 60 percent stock, 40 percent bond based on your risk profile and the projected returns needed to support your retirement cash flow, then you would want to maintain that weighting over time.

Rebalancing can also mean rebalancing within the 60 percent stock allocation. You can rebalance across asset classes such as large, mid, small cap, domestic, international, and emerging markets, and rebalance within the bonds [00:09:00] across duration and credit quality. I would say to anyone who wants to manage risk that the purpose of rebalancing is more about managing risk than it is maximizing returns.

Rebalancing helps you remove emotions regarding when to buy and when to sell by having some type of trigger for rebalancing so that you’re not having to decide in the heat of the moment. While certain asset classes or sectors may outperform in the short term, they will usually revert to their long term average.

Jack Bogle, the founder of Vanguard, once referred to this as a kind of law of gravity in the stock market, through which returns mysteriously seem to be drawn to the norms of one kind over time. A recent example to illustrate the concept of rebalancing would be to look back to March of 2020. There was so much uncertainty about COVID and the government was issuing stay at home orders and forcing businesses to close their doors.

So for example, let’s say in March you were invested in 60 percent stocks and 40 percent bonds. However, March was the time that [00:10:00] you had predetermined to be your rebalance. You’re getting ready to rebalance at a time when the market’s lost, in some cases, 10 percent in a day. The overall market loss was about 33 percent loss in 33 days during that time.

By March 23rd, stocks began to recover. If you had stuck with your rebalancing strategy during that time, then you would have probably been selling some of your bonds to buy stocks. You’re selling bonds at a time when they’re providing safety for your investment portfolio. They’re providing the ballast.

If you’re rebalancing at this time and maintain the discipline to rebalance, and then the stock started to recover by March 23rd, 2020, then you were glad that you did sell some of the bonds to purchase more stocks. The stocks. Increase substantially from March 23rd until the end of the year. Rebalancing can seem counterintuitive, but it’s smart.

It works by doing the opposite of what we most likely want to do. Warren Buffett is quoted as saying, be [00:11:00] fearful when others are greedy. Be greedy when others are fearful. And this is what rebalancing forces you to do. It forces you to sell high and buy low. When should you rebalance? There are a few different ways to look at rebalancing based on time.

Some people will rebalance on a calendar year basis, as previously mentioned, and the time frame was based on a historical returns of the market. However, this has not held up very well in recent years. Alternatively, some people rebalance monthly. Other people look at rebalancing quarterly, or semi annually, or annually.

There are many different times that you could look at rebalancing. The second way that you could look at rebalancing is by threshold. Meaning that you look at the asset allocation and determine if there has been a drift of say 2 percent or 3 percent or 5 percent or 10%. You set up the drift parameters and you say, Well, I’m only going to rebalance when the portfolio exceeds those drift parameters.

The third option would be to incorporate both time and threshold. For example, you would say, [00:12:00] Okay, I’m going to look at the portfolio every month but just because I’m looking at it, I’m not necessarily going to rebalance it. If there’s been a drift beyond the threshold, say 2%, 3%, 5%, whatever you’re comfortable with, then the higher you let the drift threshold go, the more volatility you would expect in the portfolio.

The more frequently you rebalance, the expectation would be that you’re reducing volatility. If there was anything in investing that always held to be true, everybody would do it. However, rebalancing doesn’t work all the time in the same way. Research by Vanguard is inconclusive as to the best rebalancing strategy.

Vanguard research has determined that none of the major rebalancing approaches holds a distinct and enduring advantage over others. Vanguard says, therefore, the most important consideration is for advisors to apply rebalancing to client portfolios in a consistent and disciplined manner to give clients the best chance for reaching their long term financial goals.

A few other things to consider would be tax loss [00:13:00] harvesting, and Cashflow sourcing, especially in retirement, and pulling money out of some accounts as a way to rebalance a portfolio. You also want to consider the impact of trading costs, which are almost non existent for most people these days. The bottom line is that rebalancing forces you to buy low and sell high.

It challenges you to be counterintuitive. Rebalancing is hard because you’re selling the good stuff to buy the stuff that doesn’t look so good at the time. Rebalancing helps you to remove the emotion from a buy low, sell high strategy. There’s no one optimal rebalancing schedule. The key to rebalancing is discipline.

Rebalancing is more about risk mitigation than it is about optimizing returns. And the people who need to be more concerned with risk mitigation are those who are preparing to depend on a lifetime of savings and investments to supplement their spending in retirement. For additional resources, visit Sound Retirement Planning and I’ll have links to different articles that you may find interesting on this topic of [00:14:00] rebalancing.

Announcer: Information and opinions expressed here are believed to be accurate and complete. For general information only, and should not be construed as specific tax, legal, or financial advice for any individual, and does not constitute a solicitation for any securities or insurance products, please consult with your financial professional before taking action on anything discussed in this program.

Parker Financial, its representatives, or its affiliates have no liability for investment decisions or other actions taken or made by you based on the information provided in this program. All insurance related discussions are subject to the claims paying ability of the company. Investing involves risk.

Jason Parker is the president of Parker Financial, an independent, fee based wealth management firm located at 9057 Washington Avenue NW, Silverdale, WA. For additional information, call 1 800 514 5046 or visit us online at soundretirementplanning. [00:15:00] com.