by Ben Carlson, A Wealth of Common Sense
Many of the most intelligent investment thinkers out there today are in agreement that future returns for U.S. stocks and bonds will be subpar. This has been pointed out by many for a number of years now, but eventually it will happen.
The S&P 500 is up 16% per year over the past 5 years. It would only take an annual return of 3.5% over the next 5 years to see a 10 year return number of 9.6%, the long-term average. This is a simplified example, but generally periods of above average performance are followed by periods of below average performance. Hence, an average.
One of the problems for disciplined investors in a strong bull market such as the one we have experienced the past six years is that risk management isnât always rewarded. Take a look at a simple 60/40 stock/bond portfolio with and without an annual rebalance using a $500,000 starting value:
Rebal 2
In this case you would have been better off, from a performance perspective, not rebalancing your portfolio. When this happens it can be easy for investors to become lax with their risk controls.
Now letâs look at the flipside, which is a poor performing market that so many are now calling for. The 1966-1981 period was one of the more difficult market environments to navigate in the post-WWII era for a simple stock/bond portfolio. The S&P 500 was only up 6.0% per year over this time while 10 year treasuries gained just 3.6% annually. The inflation-adjusted returns were much worse. Hereâs the same analysis from above during this time frame:
Rebal 1
Now there is a nice boost from risk management. While 0.3% per year in returns may not sound like much, you can see that small return differentials can add up to real dollars over time. Summing up both rebalancing tables, investors have been penalized during strong stock bull markets, but reaped the gains during more volatile and low-returning periods. Some people would look at these numbers and ask why they should even bother rebalancing.1
Itâs a fair question. Iâll let Yaleâs David Swensen explain:
Far too many investors spend enormous amounts of time and energy constructing policy portfolios, only to allow the allocations they established to drift with the whims of the market. [âŠ] Without a disciplined approach to maintaining policy targets, fiduciaries fail to achieve the desired characteristics for the institutionâs portfolio.
The whole point of setting a desired asset allocation in the first place is not about maximizing returns. If that was the case then it would probably make sense to have your entire portfolio invested in stocks. The point of asset allocation is to diversify your risks and manage your emotions. That means adhering to a disciplined approach by occasionally rebalancing by buying some of your relative underperformers and selling some of your relative outperformers.
I have yet to find a perfect rebalancing system. The one that works best will be the one that each investor is personally able to pull off without second-guessing the action and putting it off until later. The point of risk management is admitting that youâll never be able to perfectly time every investment move.
Risk management isnât something you can just turn on and off when you feel like it. Risk is ever present in the markets. No one really knows when bull markets are going to start and stop. Just ask anyone thatâs been calling for a top in U.S. stocks over and over again for the past three years. If we do experience lower financial market returns in the future, rebalancing and managing risk will be much more important than they have been for the past few years.
But even if future returns arenât substantially lower than theyâve been in the past, giving up on risk controls in a portfolio rarely ends well for investors.
Further Reading:
The Joy of Investing in Down Markets
What if Henry Blodgett is Right About the Stock Market
The Psychology of Lower Returns
1Itâs also worth noting that adding more diverse asset classes will usually add to the rebalancing bonus in a portfolio. This is a very simple example.
Copyright © Ben Carlson, A Wealth of Common Sense
