Avoiding Bad Luck with Rebalancing
It’s easy to be complacent as our account balances have risen over the past twelve years. The record fast market decline from COVID was offset by an equally fast recuperation, driven by large doses of fiscal and monetary stimulation. Some analysts believe innovation and millennial money will drive a bull market that lasts decades. What could wrong?
History counsels against complacency. The tension between minimizing risk and maximizing return is important to manage vs. rolling the dice on your retirement security.
Let’s recap from the prior article:
Job #1 – get your investment mix right to control portfolio variations;1 Vanguard, “Best Practices for Portfolio Rebalancing,” November 2015. p1.
Job #2 – rebalancing is selling things that have gone up the most and buying things that have went down the most.
There are three key questions to ask yourself periodically about your money and investments. Your answers will likely change over time with your goals, level of wealth, and intestinal fortitude!
1. How much risk do you need to take?
2. How much risk do you want to take?
3. How much risk can you comfortably take?
Protection from downside risk becomes more important when nearing retirement because you have less time to make up for market declines. These principles are sound for any age group, but they tend to take on more significance as time marches on. Finding the right investment mix and periodic rebalancing of the mix are vital safeguards.2Yesim Tokat, Ph.D., “The Asset Allocation Debate: Provocative Questions, Enduring Realities,” The Vanguard Group, April 2006. p2.
For example, at age 30 market risk is trivial against the risk of not saving and investing. At age 55 or 60, too much market risk may shake you out with little time to recuperate and stay on track. In other words, avoiding risk can have negative consequences as can having too much risk exposure.
The exhibits below show why it’s important to get your investment mix and rebalancing right. Together, these safeguards better protect you from bad luck, emotions, or a failure to review your goals and priorities. Risk has more than one dimension.
Exhibit 1: The Rule of You Can’t Spend an Average
The three portfolios in the chart below have the same average rate of return over thirty years in retirement. Each also withdrew the same amount of money every year. The only difference between the three is the sequence of returns. We can’t control or guess the up and down sequence of market returns. But we can control how we adjust spending and manage risk. Rebalancing with discipline helps mitigate Bad Luck and running out of money.
Exhibit 2: Risk and Return – What’s the Right Mix for You
This table helps you gauge your downside against return potential. Too much aggression may not serve you well as you near retirement. Once the right mix for you is established, rebalancing to a “threshold” helps avoid emotional, money losing attempts to time market movements.
In Exhibits 3 and 4, we use an example of a 10% threshold to compare a conservative and an aggressive mix in up and down markets.
Exhibit 3: Rebalancing During a Falling Stock Market
50-50 Stock/Bond Mix: a 27% stock market decline reduces stock from 50% to 40% and hits the 10% target “threshold.” The overall portfolio falls only 9%. The mix enables you to protect capital and buy stock at lower prices back to the initial 50-50 mix. In the process, your future return potential is higher because you bought more stock. The additional stock helps offset the inflation-compounded withdrawals which would otherwise delete your capital more rapidly.3Michael Kitces, “Managing Sequence of Return Risk with Bucket Strategies Vs. A Total Return Rebalancing Approach,” November 12, 2014. p7.
This is why conservatism generally makes sense for most people who are close to, or in retirement.
90-10 Stock/Bond Mix: Compared to 50-50, the same 27% stock market decline reduces stock from 90% to 86%. The overall portfolio falls 23%. This mix does not protect your downside and leaves you less cash to buy stocks when they are low. This is why it seldom makes sense to own high levels of stock as you get closer to retirement.
Exhibit 4: Rebalancing During a Rising Stock Market
50-50 Stock/Bond Mix: A 62% market increase triggers a rebalance from 60% back to the initial 50% target. The selling stocks as they increase lets us rebalance and/or spend the excess profits. Selling high helps to fund retirement spending along with income generating assets.4Michael Kitces, “Managing Sequence of Return Risk with Bucket Strategies Vs. A Total Return Rebalancing Approach,” November 12, 2014. p7.
90-10 Stock/Bond Mix: Compared to 50-50, a 62% market increase only moves stocks from 90% to 93%. This mix gives you less flexibility to take advantage of market volatility. In the growth stage, maintaining high stock levels gives you superior long-term compounding potential.
Exhibit 5: What Are the Odds of Decline?
We don’t have the luxury of do-overs in retirement. Without being prepared for market or spending uncertainties, can leave you exposed to risk when you can least afford it.
Summary
The retirement planning puzzle has many pieces. From an investment perspective, it’s vital to have a mix that is consistent with your goals, facts, and circumstances. Establishing buy or sell thresholds are not a timing vehicle, they are a strategic guide to rebalancing your portfolio. Research has demonstrated that rebalancing too often can hurt returns without reducing risk.5Gobind Daryanani, “Opportunistic Rebalancing: A New Paradigm for Wealth Managers,” Journal of Financial Planning, 2007.
Every decision has tradeoffs to understand. When you’re young you can afford higher risk levels because you have the luxury of time. When you’re not as young as you used to be, more scrutiny of investment risk is important to protect your retirement security.
Jerry Matecun – Founder, President
Expert guidance to plan your future, preserve your lifestyle, and retire with confidence. For a confidential consult, contact me at jerry@compoundvalue.com.
FOOTNOTES
- 1Vanguard, “Best Practices for Portfolio Rebalancing,” November 2015. p1.
- 2Yesim Tokat, Ph.D., “The Asset Allocation Debate: Provocative Questions, Enduring Realities,” The Vanguard Group, April 2006. p2.
- 3Michael Kitces, “Managing Sequence of Return Risk with Bucket Strategies Vs. A Total Return Rebalancing Approach,” November 12, 2014. p7.
- 4Michael Kitces, “Managing Sequence of Return Risk with Bucket Strategies Vs. A Total Return Rebalancing Approach,” November 12, 2014. p7.
- 5Gobind Daryanani, “Opportunistic Rebalancing: A New Paradigm for Wealth Managers,” Journal of Financial Planning, 2007.
PLEASE NOTE: Nothing herein constitutes investment, legal, or tax advice. For details please see Disclosure.
