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Portfolio Rebalancing

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CampFireJack

CampFireJack

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  • #1
I can honestly say that I believe the concept of rebalancing has saved my investment strategy. Before I learned what it was and how it could benefit me, I randomly chose and bought investments I thought would do well, whether they be stocks or bonds. My decisions had neither rhyme nor reason. Some of my investments did well and some didn't. I can tell you with confidence that none were for the long term. If someone had asked me back then what a long term investment was, I'd have looked at them blankly in the face. No idea. I suppose you can say that I had no strategy.

I believe the year was 2008 when I bumped into MarketRiders. Back then, the website was filled with great information that taught me a lot. They seem to have pared it down these days. They also don't focus nearly as much on the rebalancing aspect of their outlook. Today, they much more prefer to advertise the simplicity and value they offer to their customers overall. But really, they have rebalancing at their heart. Perhaps they discuss that more once you're a paying member. I was for a while, but then I grew out of their service and went on my own. I think I've been doing fine since. Although, if I had enough invested, I'd likely do with them again. It's such a hands-off approach.

The concept of rebalancing is used by some of the most wealthy institutions and educated people on earth. From Nobel Laureates to ivy league institutions to huge corporations, rebalancing is the fundamental principle that guides their investment philosophies. And really, from what I've been able to gather through the years, the concept isn't so much about making a return, but more about not losing their current dollar's value. It's much more about risk mitigation than it is about beating the market. After all, even if you beat the market for 15 straight years and then a depression ensues and all of your equities tank, you're probably going to wish you had focused more on risk aversion than positive returns. But don't get me wrong. Rebalancing is also a great way to make money in the markets. I'll discuss all that below.

What is Rebalancing?

I'll explain it to you the easy way. Let's pretend you have two investments. When one goes up, the other usually goes down. They have nearly no correlation. In the investing world, these two uncorrelated assets are usually described as stocks and bonds. When bonds go up, stocks like to fall and vice-versa. Really, they do. In normal markets in the real world.

When you initially purchase these two assets, you'll decide on how much you'd like to buy of each. So if you have a total of $10,000, you might want to go with a 50/50 split. You'll spend 50% of your money on stocks and the other 50% on bonds. It's that simple. The reason you might want to spread your money out like this is because while you would like to make a nice juicy return on your stocks, you'd also like to preserve some of your wealth in a safer asset class like bonds if something terrible happens. So that's pretty much it. You want to make money the safest way possible and you figure a 50/50 split between stocks and bonds is the way to do that. We call this a weighted portfolio. Each of your assets consume a specific weight of the overall.

Here's the thing. Markets move. They rarely, if ever, stay the same. What if in one year, the value of your stocks rose to consume 70% of your entire portfolio and the bonds fell to consume only 30%? I'd say that your portfolio is out of balance. That's not a good thing because it just became much more risky than the one you formed in the outset. In general, stocks are a more risky asset class to own than bonds are. By allowing your stocks to rise to 70% of the overall value of your portfolio, you just exposed yourself to more risk than you originally wanted to. If it were the other way around and bonds rose to 70%, that would be fine if all you wanted to do was to avoid risk. But bonds usually pay less than stocks do, so while you'd be averting risk, you'd also be making less money. You'd certainly want to correct that.

How Does Rebalancing Work?

If you originally invested $10,000 and it didn't grow at all, you'd have that $10,000 no matter what happened. Just like in the example above, stocks went up, but bonds went down. What you made on one, you lost on the other. That's fine. You still have the amount of your original investment. Your balance is out of whack though and you need to get that back to what you originally intended.

To rebalance your portfolio, you'd generally sell some of the stocks you own and take the proceeds to buy some bonds. You'd do the math and figure out how much you need to sell and how much you need to buy to put you back at that 50/50 mark. This is essentially what MarketRiders sells. It's their business to follow both the markets and your investment portfolio and tell you what to do, given certain times of the year. They do more than that as well, but this is the crux of it.

What's Asset Allocation?

Up above, I gave you a very simple example. Owning 50% of stocks (let's say the S&P 500 ETF VOO, for example) and 50% of bonds (let's say the overall bond market ETF BND, for example) is probably the most simple mix available. Even though it's simple, I know many very wealthy people who swear by it, so don't ever think that simple is bad. Each of the ETFs you own would be considered an asset. Each one is also allocated at a certain amount. So your asset allocation, in this case, would be 50% VOO at $5000 and 50% BND at $5000.

Things get slightly more complicated when you begin to introduce more assets. I'll actually be writing another post that discusses asset allocation in all its glory later on, so I won't get into all that right now. Just know that each stock, ETF, or mutual fund you own is considered an asset that's got a specific value allocated to it.

How Often Should You Rebalance?

There's a lot of debate about this topic, but it's generally been settled that there are two popular instances in which an investor may want to rebalance their portfolio. The first instance revolves around the calendar. Many investors will choose to ignore their investments until a certain day falls on the calendar. This can happen once, twice, three times, or more a year. It's really up to the investor. They'll ignore everything until certain dates arrive and then they'll dive into their portfolio to see what needs to be bought and what needs to be sold. This is actually a quite common strategy.

Other investors, however, prefer to take a more hands on approach. They'll ignore calendar dates in general and wait until a shift in the market occurs that's large enough to warrant their attention. When things get out of whack enough, they'll go in at any time to do their buying or selling. If I had to guess, I'd say that younger investors have the energy to watch the markets and follow this strategy while older, more seasoned investors use the calendar based one.

What Would Trigger a Rebalance?

Whichever rebalancing strategy you choose, there's never any reason to guess. It's all in the numbers. When you look at your portfolio, no matter if it's on a certain date or if a market event has occurred, all you need to do is calculate how far off your original asset allocation percentages you are. So if you discover that your stocks have shifted 10% and your bonds have shifted the same, you can do your rebalancing then. Some investors choose to use a 5% trigger and some prefer to us a 15%. It depends on investor interest and how much each investor is paying for trades. If an investor is paying for each trade and they don't have much money invested, it might not make much sense to execute many trades per year. Perhaps a yearly rebalancing strategy would make the most sense in that case.

So that's it in a nutshell. I hope I've given you some background into this wonderful world of portfolio rebalancing. In my next few posts, I'll discuss how you can make money with a rebalancing strategy as well as what types of asset allocations make the most sense and why. If you've got any questions, please ask down below.
 
CampFireJack

CampFireJack

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  • #2

Pros & Cons of Portfolio Rebalancing​

There are some very good posts in this forum that discuss portfolio rebalancing and asset allocation, so I encourage you to read those before you read this one. This post is a teeny bit more advanced than they are and it's intended to follow both.

In this post, I'd like to touch upon a very small sliver of one of the potential pitfalls of rebalancing and how you can overcome that pitfall. But first, let me say that asset allocation combined with portfolio rebalancing is an incredible strategy to reduce risk and to grow your investments. While you may think that you should buy up those hot stock picks with all your money to get the biggest returns, you'll be thankful you didn't when the stocks ebb and flow and potentially force you to sell. It really is all about diversity and risk aversion and that's what both of the aforementioned concepts try to manage.

Let me give you a personal example to make my point of this post. Back a few decades ago, when I first began investing, I thought that all I needed to do was to purchase a few stocks or ETFs. There was so much information on both that I was really overwhelmed. I had heard about various investment strategies, but I never really took any seriously. When it came time to buy some assets, I took a shot in the dark. As you can well imagine, things didn't go so well. I had no idea what short or long term investing was and I really didn't have any goals in mind. All I did have was a small pile of cash and some knowledge that I needed to put that cash into something so it wouldn't get eaten away by inflation. So a few random stocks it was.

Years later, I discovered asset allocation and portfolio rebalancing. It was at this time when I began purchasing a very basic stock ETF as well as a just as basic bond ETF. If you're curious, I bought VOO and BND, just like pretty much everyone else out there does. At the time, I believe I had a 60% stock and a 40% bond mix. As time went by, I noticed that the percentage of each holding either went down or up and as time also went by, I bought and sold portions of these investment according to the fundamentals of portfolio rebalancing.

Now here's where things get interesting. During the time I had initially purchased these investments, the longest running in history equity bull market was taking place in the stock market. Equities were flying higher and higher as each month passed while bonds were growing, but not nearly as much as stocks were. My equity ETF, VOO, was gaining value rapidly while my bond ETF, BND, was gaining value, but not as fast. For the sake of example, let's say that VOO was growing at 20% per year while BND was growing at 5%, which as you can imagine was throwing my asset allocation out of whack.

So here it is; since I had to continuously rebalance my accounts to realign my 60/40 mix of assets, I spent a lot of money on transaction costs. I didn't like that very much. Also, since the equity market was growing so much more rapidly than the bond market was, I didn't really enjoy selling off my high performing and value gaining equity ETF only to purchase a lesser performing bond one. What I was doing seemed counter intuitive to my investing goals. If I had simply left things alone, I could have made a lot more money.

Now, the reason I was okay with this at the time was that I thought the market was in a bubble. Equities were growing, but I felt that they'd soon come crashing down and when that happened, I'd have saved myself a lot of money by selling so much off before that happened. I'd have all these safe bonds and hardly any equities and I'd be in great shape. Well, unfortunately the equity crash didn't happen. What did happen was that they kept on climbing and they're still climbing today. I honestly don't think they'll ever come down due to all of this market manipulation by the central banks of the world. The amount of cash in the global system is growing and growing.

The question now is, how do we effectively rebalance our accounts without selling off our high performers? Well, I figured this out long ago and a great many folk out there seem to agree. The trick is to incorporate dividend paying ETFs, such as VYM, into the mix so that when it comes time to rebalance, all you need to do is purchase the lesser performing asset with the dividend proceeds. VYM is a great dividend payer and BND isn't terrible in its own right. So, if the percentages of my portfolio change to 70/30 because of the growth of equities, then all I need to do is continue to purchase BND with the dividends I earn. This will keep the ratio stable. And if you think about it, if you purchase your ETFs this way, you'll always be buying low, which is obviously the goal with any investment.

If you'd like to read up on this topic, here are two articles I recommend:

https://www.thebalance.com/the-case-against-rebalancing-your-portfolio-4160045

https://www.theglobeandmail.com/glo...rly-rebalancing-your-portfolio/article573966/

Also, if you have any investment suggestions or advice, I invite you to reply to this post down below. I'd love to hear from you.
 
CampFireJack

CampFireJack

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  • #3

Instructions for Making a Portfolio Rebalancing Spreadsheet​

It's almost as if figuring out your favorite asset allocation is the fun part. After all, you're going shopping and there are thousands of assets to buy. I personally enjoy perusing all the options and picking out what I like best. The issues arise when it comes time to determine exactly how many ETF shares you'll buy and how you'll track the percentages owned of each one. If you're not organized, things can get hairy very fast.

There are a few different routes you can take when you need to begin tracking your portfolio. You can use a paid service such as MarketRiders, Pure Financial Advisors, or a robo advisor that handles rebalancing automatically. Most online brokers offer this last service for a small fee. The thing is, now that most trade commissions are free from most online trading services such as ETrade, TD Ameritrade, and Charles Schwab, there's no reason you can't do this yourself. All you need to do is create a simple spreadsheet and keep it up to date. Sure, you'll need to do a little extra work such as reminding yourself to update the values of each asset and performing the trades themselves, but I'm sure you're quite capable of this. After all, you're reading a post such as this one, which goes to show how astute you are. I set my own portfolio rebalancing spreadsheet up in Google Sheets and I set reminders in Google Calendar, so it's all free. There's no cost to me at all. And really, I much prefer it this way. I enjoy being involved.

To create my spreadsheet, I followed the instructions given in this video. It was really easy to do. Google Sheets has all the necessary functions. Watch the video and ask any questions you might have down below.

 
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