PP is not as Passive as you might think..

[blackomen]

Actually, any asset allocation with a set of default weights for each asset and a rebalancing corridor is not completely passive.

Let's take a look at a very simple asset allocation: 50% Stocks, 50% bonds, a 10% rebalancing corridor on either side (so if something reaches 40% or 60%, we rebalance to 50%.)

If you buy such a portfolio and never rebalance it, then after X years, your return will equal the average of the return on the stock index and the bond index (say 0.5*(SPY + TLT) )

The stats for the 50/50 portfolio are here: https://web.archive.org/web/20160324133 ... l-returns/

If you bought both @ 50% in 1974 and never rebalanced, then your return in 2011 would be (10.4 + 7.9)/2 = 9.15%, but the return with rebalancing becomes  9.5%.

How's that possible?

My way of looking at it is that rebalancing is a form of market timing that works, at least if you have asset classes that aren't highly correlated.  When you go 50/50 stocks and bonds, you trade stocks according to the following rule:

When the ratio of stocks to bonds exceeds 60:40, you sell stocks and buy bonds to restore the ratio to 50% each.
When the ratio of stocks to bonds falls below 40:60, you buy stocks and sell bonds to restore the ratio to 50% each as well.
And each time you rebalance, you reset the indicator.

So you're basically timing stocks with the aid of Bonds as an indicator and you're also timing bonds with stocks as an indicator.

The same concept can be extended to the Permanent Portfolio where you're trading Stocks by using Gold, Bonds, and Cash as an aggregate indicator..  similar idea for all the other assets..  for any asset, you're timing its buying and selling using the other 3 uncorrelated assets.

So why does this view matter?

Well, a lot of skeptics dismiss the PP because they don't like Gold, Bonds, or even Stocks and feel these assets will lose money in the long run.  If you hold a completely passive PP, it's gonna be hard to make much money over the long run when 3 of the 4 assets fail to make any meaningful real returns over the long run.  Only stocks make real returns long-term but the other 3 assets tend to rise, often dramatically, when stocks fare poorly.  So when you hold them, not only are you hedging your stocks but you're also naturally given an excellent indicator for market timing when you should add/reduce your exposure in any of the asset classes.  This can also explain why the PP can maintain a fairly competitive return compared to, say, 100% stocks which has several times the volatility.

[Stewardship]

My way of looking at it is that rebalancing is a form of market timing that works, at least if you have asset classes that aren't highly correlated.

My way of looking at it is the market timing aspect of rebalancing may or may not work.  If it has worked over the last few decades, then great, but I wouldn't expect it to always work.  It isn't difficult to imagine economic scenarios where the PP as a whole doesn't keep up with it's best-performing allocation or the timing aspect of rebalancing has a negative outcome.

The benefit and purpose of rebalancing is assuring any economic threat to your portfolio remains neutralized.  The timing aspect is a by-product which we are not seeking, because the primary purpose of the PP is wealth preservation under any economic conditions.  Sure you can beat the PP, but not without increasing your exposure to adverse economic conditions.

[dualstow]

There's an old joke that it's ok to engage in market timing as long as you call it rebalancing.

[MediumTex]

There's an old joke that it's ok to engage in market timing as long as you call it rebalancing.

Is it market timing if you always feel weird about whatever asset you are buying?

[dualstow]

I think I see what you're getting at. They both happen when an asset is "low", but market timing probably feels better, like when you have an urge to sell long bonds because interest rates have nowhere to go but up. Rebalancing in the pp does not, like when you have to buy gold just as everyone's telling you gold is finished and will not come back up in your lifetime.

Something like that?

[Tyler]

At its core, market timing is the act of making an investment decision based on a perceived insight into the future.  This insight can be a result of inside information, personal prediction, or quantitative model prediction.  By this definition, rebalancing your portfolio based on a gut feel or trend analysis also qualifies as market timing.

Rebalancing based on target portfolio percentages is different to me because it is future-neutral.  It makes adjustments based on your present-day portfolio, not what you think it will look like a month from now.  That's why rebalancing based on target percentages is often painful -- it may often go completely against your prediction for the future.  It's also why it is so effective at minimizing investment risk. 

[jason]

It's even more striking if you look at the performance of the PP, as a whole, since January 1, 1972.  According to http://www.peaktotrough.com/hbpp.cgi which calculates historical PP performance, if it was never rebalanced, the CAGR would have been only 7.10%.  With 15/35 rebalancing, the CAGR was 9.22%  That is quite a huge difference.  It shows the growth of $10,000 to only $183,166 without rebalancing and to $421,547 with rebalancing.  That is an ending capital value that is literally more than double with rebalancing!  It's pretty amazing.

[Xan]

But, as I think Kstartle demonstrated, rebalancing is not necessarily a CAGR win.  Over any given time period, it may help or it may hurt.

Its purpose is to keep the portfolio from drifting into depending too much on a single asset.

[Kshartle]

But, as I think Kstartle demonstrated, rebalancing is not necessarily a CAGR win.  Over any given time period, it may help or it may hurt.

Its purpose is to keep the portfolio from drifting into depending too much on a single asset.

Hey thanks Xan

Rebalancing is a good idea for a lot of people and a lousy one for others. It's for maintaing an acceptable level of volitility.

It's certainly not a magic recipie for higher returns and almost certainly diminishes them over long periods since stocks should almost certainly outperform for very real reasons over the long run (20-30 years or more).

[Xan]

Hey, when you're right, you're right.  :-)

[Kshartle]

Hey, when you're right, you're right.  :-)

I consider it luck when I'm right and someone else's fault when I'm wrong. Keeps the pressure off.

[Kshartle]

It's even more striking if you look at the performance of the PP, as a whole, since January 1, 1972.  According to http://www.peaktotrough.com/hbpp.cgi which calculates historical PP performance, if it was never rebalanced, the CAGR would have been only 7.10%.  With 15/35 rebalancing, the CAGR was 9.22%  That is quite a huge difference.  It shows the growth of $10,000 to only $183,166 without rebalancing and to $421,547 with rebalancing.  That is an ending capital value that is literally more than double with rebalancing!  It's pretty amazing.

Something sounds funky about this.

When I run it without rebalancing I get CAGR of 8.15% and 278k.

You want to click "reinvest interest and dividends". That way stock returns stay as stock and bond returns stay as bonds. If you don't they are essentialy being rebalananced into cash all the time.

If you had just a stock portfolio and didn't reinvest by the end you have 183k in stocks and 80k in T-bills. Not really the same as a stock portfolio which reinvested ends at 475k 

[Kshartle]

My way of looking at it is that rebalancing is a form of market timing that works, at least if you have asset classes that aren't highly correlated.

My way of looking at it is the market timing aspect of rebalancing may or may not work.  If it has worked over the last few decades, then great, but I wouldn't expect it to always work.  It isn't difficult to imagine economic scenarios where the PP as a whole doesn't keep up with it's best-performing allocation or the timing aspect of rebalancing has a negative outcome.

The benefit and purpose of rebalancing is assuring any economic threat to your portfolio remains neutralized.  The timing aspect is a by-product which we are not seeking, because the primary purpose of the PP is wealth preservation under any economic conditions.  Sure you can beat the PP, but not without increasing your exposure to adverse economic conditions.

+1 for thinking!

[jason]

It's even more striking if you look at the performance of the PP, as a whole, since January 1, 1972.  According to http://www.peaktotrough.com/hbpp.cgi which calculates historical PP performance, if it was never rebalanced, the CAGR would have been only 7.10%.  With 15/35 rebalancing, the CAGR was 9.22%  That is quite a huge difference.  It shows the growth of $10,000 to only $183,166 without rebalancing and to $421,547 with rebalancing.  That is an ending capital value that is literally more than double with rebalancing!  It's pretty amazing.

Something sounds funky about this.

When I run it without rebalancing I get CAGR of 8.15% and 278k.

You want to click "reinvest interest and dividends". That way stock returns stay as stock and bond returns stay as bonds. If you don't they are essentialy being rebalananced into cash all the time.

If you had just a stock portfolio and didn't reinvest by the end you have 183k in stocks and 80k in T-bills. Not really the same as a stock portfolio which reinvested ends at 475k

That's a good point.  If run with stock dividends being reinvested, it does come out to 278K, which is still way below the 422K you would have in the end with 15/35 rebalancing.  This does not prove that rebalancing always helps, but it has certainly helped the PP a lot since January 1, 1972.

[jason]

You may want to look at results since ~1976, since the PP wasn't available to investors until Gold was legalized in 1975.  The return data from the early 70's has a significant effect on backtesting, but gold wasn't tradable in those years so I think its most realistic to exclude those early years from backtesting. 

Gold returned 48.66% in '72, 71.24% in '73, and 72.02% in '74.  Those are some large returns that weren't realized by individual investors.

By starting January 1, 1976, that narrows the gap quite a bit.  CAGR without rebalancing with reinvesting dividends was 8.41%.  CAGR with 15/35 rebalancing without reinvesting dividends was 8.88% and with reinvesting dividends was 9.03%.  Still a sizable difference, though.

[MachineGhost]

Rebalancing based on target portfolio percentages is different to me because it is future-neutral.  It makes adjustments based on your present-day portfolio, not what you think it will look like a month from now.  That's why rebalancing based on target percentages is often painful -- it may often go completely against your prediction for the future.  It's also why it is so effective at minimizing investment risk.

Successful market timing is based on present day conditions, not forecasting.  I've yet to see anyone forecast sucessfully and consistently, whether human or machine.  Market timing is easy so long as you don't let irrational human behavior intrude into it.  But forecasting?  Maybe in 10 more years with super-advanced AI.

[blackomen]

Rebalancing based on target portfolio percentages is different to me because it is future-neutral.  It makes adjustments based on your present-day portfolio, not what you think it will look like a month from now.  That's why rebalancing based on target percentages is often painful -- it may often go completely against your prediction for the future.  It's also why it is so effective at minimizing investment risk.

Successful market timing is based on present day conditions, not forecasting.  I've yet to see anyone forecast sucessfully and consistently, whether human or machine.  Market timing is easy so long as you don't let irrational human behavior intrude into it.  But forecasting?  Maybe in 10 more years with super-advanced AI.

When it comes to market timing, humans are better at detecting and adapting to regime changes than machines but can be prone to emotions and careless mistakes which can instantly erase all the gains you've worked so hard to make (i.e. by forgetting a stop loss)

[Stewardship]

I think I see what you're getting at. They both happen when an asset is "low", but market timing probably feels better, like when you have an urge to sell long bonds because interest rates have nowhere to go but up. Rebalancing in the pp does not, like when you have to buy gold just as everyone's telling you gold is finished and will not come back up in your lifetime.

Yeah, like what everyone was saying about gold when it was at $300/oz. 

[Kshartle]

It's even more striking if you look at the performance of the PP, as a whole, since January 1, 1972.  According to http://www.peaktotrough.com/hbpp.cgi which calculates historical PP performance, if it was never rebalanced, the CAGR would have been only 7.10%.  With 15/35 rebalancing, the CAGR was 9.22%  That is quite a huge difference.  It shows the growth of $10,000 to only $183,166 without rebalancing and to $421,547 with rebalancing.  That is an ending capital value that is literally more than double with rebalancing!  It's pretty amazing.

If you run from Jan 1, 1981 through today the CAGR for rebalancing is 8.05% and for non-rebalancing it's 8.26%

That's over 33 years where non-rebalancing acheived a higher return than rebalancing 35/15 did.

Any idea that rebalancing provides a certain return bonus must assume a longer time period than 33 years.

Obviously there isn't one. A longer time period will not ensure a higher return for the rebalanced portfolio. I think very likely the longer you go the less likely rebalancing will help you return-wise.

I'm not saying this to rain on anyone's parade, but I think it's better to not hold a false belief.

[buddtholomew]

Re-balancing returns the portfolio to its initial risk profile at the expense of capturing momentum in one or more assets. Any incremental gain achieved via re-balancing should be considered icing on the cake.

[Kshartle]

Re-balancing returns the portfolio to its initial risk profile at the expense of capturing momentum in one or more assets. Any incremental gain achieved via re-balancing should be considered icing on the cake.

Yes.

And any incremental losses due to re-balancing are just a neccessary evil for keeping investment volatility in-line with what you can handle.

[MachineGhost]

And any incremental losses due to re-balancing are just a neccessary evil for keeping investment volatility in-line with what you can handle.

Which is why a better way to go is track the momentum of the individual assets individually and only sell that asset when necessary, so you don't interrupt the momentum of the others.