That’s not quite market timing (it is panic selling) but it usually is the outcome of investing without a plan. Why are we investing, what are we investing for and what are we investing in is super-critical to know if we have a fighting chance to stick with our investments during eventual market declines.

Because without that, without that conviction, we’ll end up making decisions that are more emotions-driven than following a blueprint on what to do when such downturns occur.

And they will recur because volatility, I mean ups and downs in the prices of stocks, is inherent with the stock market but given enough time, stocks will and do recover to reach new highs.

As they did from the last time around when stock prices dropped big. That is again a feature of how the stock markets work. 

So to give you a primer on how difficult this market timing game is, take for example the year 2020 that started off just like any other year. And then came this little virus out of nowhere and the entire world stopped. I mean no school, no restaurants, no travel. The economy suddenly literally ground to a halt.

And we know what that means. A big stock market crash. And it happened. They say it was the fastest decline in the value of businesses by the extent the stock market dropped.

But then the market recovered and that too in a matter of weeks.

But had you sold at the bottom and many people did assuming things were going to get a lot worse, well, now you have a problem. 

And that always is the big danger. I’ll get to the why later but let’s run through some numbers on why it would have been a bad idea to even attempt to time the market.

So there were 253 total trading days in the year 2020. Had you stayed invested all through the year and though not ideal, if all you owned was a large company fund like the S&P 500, yes, you would have had to live through intense volatility but you did good. I mean you made 15.29 percent on your money.

But had you sold to buy back into the market at a later point and missed the single best day, your return for the entire year would have dropped by two-thirds.

So miss just one day and your return drops from 15.29 percent to 5.40 percent. That’s crazy.

And that usually is the most likely outcome if you were to attempt this market timing thingy since you’d always tend to get out at the worst possible days and the worst possible days are almost always followed by the best recovery days.

The best days are again lumped together and had you missed the best two days, you might just have been better off keeping your money safe in a savings account. Because missing just two of the best days turned a positive year into a negative one.

The plots below show all this in percent and dollar terms so don’t market time.

But why show missing only the best days? What would it look like if I were to miss the worst days of the year?

Fair question and you’d be right. You’d have quite a bit more money if you were able to somehow navigate out of the market before the worst possible days and were somehow able to get back in time to enjoy the recovery.

And the data that shows just that.

But we all know how hard that is. I mean the math is plain impossible. Let me show you why.

So there were 253 trading days in the entirety of the year. Your chance of missing the single worst day is of course 1/253 = 0.004 or 0.4 percent. Not only are your odds low but even if you timed it perfectly, it’s not like you made the kind of killing that would have changed your life.

Missing the two worst days brought you quite a bit more money but then your chance of successfully pulling that off is 1/253 x 1/252 = teensy tiny small. You might as well play the lottery.

And of course being able to time the market that lets you avoid all five of the worst days are out of the world remote.

So don’t market time.

And all this ignores tax consequences and all that time you’ll spend away from what you are good at, constantly watching the markets and the emotional heartaches that’ll bring you. Because trust me (my dad), this thing can be quite draining.

So again, don’t market time.

And the same plays out over longer timeframes.

Miss the 20 best days out of thousands over this 15-year stretch and you might just have parked your money under your mattress.

And here’s the biggest problem with market timing. Say you sell at the worst possible times thinking that things would get even more worse and they do, there is almost no chance you’d be willing to pull the trigger to get back into the game because then you’d wait for things to get even more worse.

So you wait and out of nowhere, the market turns and turn it does violently. That is what always happens. And now it goes past the point you sold at.

Now you are stuck, hoping and praying it (the stock market) falls again. And it never does. Because stocks as a collection are inherently designed to rise in the long run. They must. That’s the nature of the game.

So again, don’t market time. Don’t give up on the guaranteed returns that the global stock markets will deliver over time for that fake allure of being able to dance in and out of the markets.

And the best way to protect against caving to that lure of market timing is to follow a plan. Any plan, regardless of how sub-optimal it might appear to be is better than no plan. And then come hell or high water, stick to that plan.

I bet you’d come out a-okay.

Thank you for reading.

Cover image credit – Monstera, Pexels

But this apparently normal behavior somehow escapes the process of purchasing financial assets. And hence, an entire field of finance devoted to trying to understand why investors act the way they do while exhibiting perfectly rational behavior in other walks of life.

But I think investors behave the way they do because most fail to make a connection between buying say a box of Tide detergent versus buying shares in Procter & Gamble that makes that detergent.

And if we dig deep enough with anything we do or consume in our daily lives, there is always somewhere a connection between a product or a service and a business that delivers that product or a service. And that business, if publicly-traded, we can also own a piece of.

My younger daughter is all things LEGOs these days. I mean she spends hours building things like these…

And her gang is into it as well so we know she is not alone.

So then the discussion as usual leads to buying a piece of the LEGO making business. But she can’t because LEGO does not trade publicly.

But then that plastic that makes those LEGOs could be coming from a publicly-traded business. Or that oil that was dug up to make that plastic had to have a publicly-traded entity behind it. And so would the businesses that make those machines to injection mold these pieces or that steel that was used to make those machines or those semiconductor chips that control those machines and on and on.

So if she owned a diversified basket of global stocks, somewhere, somehow, she owns a piece of the supply chain that went into making those LEGO pieces. So she is all squared then.

Talk about supply chain, if you never came across this Milton Friedman video, well, you did now.

So the other day, I dug up some old notes and this one dates back to June 2nd of 2012. And that scribbling was all about yields – bond yields vs. earnings yield for a portfolio of global stocks. Earnings yield by the way is the inverse of price to earnings ratio.

So the 10-year Treasury bond yielded 1.5 percent at the time when global stocks were yielding 8.5 percent (price to earnings ratio of about 12). Global stocks here refers to the FTSE Global All Cap Index.

Stocks were a bargain then. How sweet of a bargain? The last time the spread was as wide was all the way back in 1962.

And yet investors were dumping stocks left and right, for some reason or the other and at the time, that reason appeared to be the Eurozone debt crisis. In just the April of that year (2012), U.S. investors sold a net total of 20 billion dollars worth of stocks. In May, they withdrew 26 billion dollars from the stock market.

All in all since 2007, investors withdrew some 530 billion dollars out of stocks and stock-type investments.

And where did most of that money go? Into the apparent safety of bank savings account and into bonds.

But that at the time could be considered as a reasonable behavior. Not right, not logical but reasonable. Investors were terrified of the slightest of turbulence. The trauma of the Great Recession was fresh in everyone’s mind.

And hence the equity risk premium. Stocks are risky because profits are not guaranteed. But if there was no risk, the earnings yield for stocks would collapse to meet that of bonds.

But earnings or profits for businesses can and do fall. And that causes the value of these businesses and hence the stock prices to fall. So the risk.

But in hindsight, that was THE time to plow everything you had into the markets.

And what was predicted at the time to be a great time to invest was indeed a great time to invest. I mean if you were anywhere close to the stock markets this past decade, you made money.

So where are we now? The bond yields are about the same but the earnings yield for stocks have basically cratered. That is, the equity risk premium got reduced.

And most of that reduction in the equity risk premium happened because of the expansion in multiples. I mean you were paying 12 times earnings for a portfolio of global stocks in 2012. Now you are paying 17 times that.

But then it sort of makes sense. Besides that small hiccup at the onset of COVID, we have basically forgotten what risk is. The Great Recession is a distant memory. The Dot-com crash of the early 2000s is like it never happened.

And hence the complacency.

What do I personally wish? I wish for a renormalization of interest rates. That’s assuming we know what “normal” is in the interest rate world. Maybe we are in a new era and maybe we never go back to the way things were but I think we must considering all the craziness that is out there in the markets these days.

I want things to reset a bit. I want the bond yields to grow and the equity risk premium to expand back up. So technically a double hit on the price of stocks.

Painful yes, in the short run but ideal for most of us in the long run. We rather take the medicine now than having to surgically remove a tumor later. Bubbles are painful when they deflate.

So if you are a millennial or a Gen Xer, you should get down on your knees and pray for a decade of flat returns. That’ll allow you to pump as much powder as possible into the markets while the bond yields normalize and the equity risk premium reflates.

None of it says that you sell your stocks. Because no one knows the future and you don’t want to get into the game of predicting the future. But if you’ve got a reasonable plan and a decent portfolio that fits that plan, you can tweak and make adjustments to that portfolio where and when necessary but you must stick to that plan.

That of course requires conviction and conviction only comes with knowing what you own is what you should own but once that’s done, all you can and all you should do is throw as much savings as possible into that plan and wait.

Thank you for reading.

Cover image credit – Tran Long, Pexels

And then there are the minimalists and there is a spectrum amongst them. The hard core ones are the planet-first kind who do everything they can to conserve and preserve. Think living off the land and off-grid.

And then there are the pseudo-minimalists who are the mindful consumerists. They do everything within reason to conserve and preserve but prefer not to take it to extremes even if they could afford to.

But wherever you are on that minimalist spectrum, that conservation and preservation mindset by default leads to wealth accumulation.

But ask any 6th-grader who between the two – the uber-consumerist or the minimalist – they think is wealthy and by default, they’d pick the uber-consumerist.

That’s how we are wired. What shows is what counts.

But it’s the minimalist likely swimming in cash while the uber-consumerist is one paycheck away from disaster. That’s the classic rich vs. wealthy debate. People who look rich might not be wealthy and people who appear run-of-the-mill own real wealth.

And you’d think the rich and the wealthy are the same and though there are similarities, there are big differences.

Rich is a state which is more current or transitory. Lottery winners, newly discovered celebrities, star athletes, folks working in high-paying professions such as medicine and law are the rich. They have quite a bit of money flowing in with most of it derived from a single source.

And the rate of outflow sometimes equals or exceeds the rate of inflow. The rich as a state can happen instantly and then it disappears.

Wealth on the other hand is more permanent. It comes through ownership of income-producing assets – enough assets that allows for a life full of choices.

And the income that these assets produce grows with time to a point where it surpasses income needed to support one’s daily existence.

So whether you work or not or if the skills you possess are in demand or not, your standard of living remains unaltered. If the same thing were to happen to a merely rich person, he would quickly become poor.

Wealth buys freedom. Enough wealth that the income it throws surpasses the income you need to live comfortably. Enough wealth that you can stop doing anything remotely resembling work and instead do something that you always wanted to do but couldn’t. You want to work for a non-profit that hardly pays anything, you have the freedom to do that. That business you always had an itch to start, you can do that. Or if all you wanted is to sit back and retire, you can do that too. All of that without impacting your quality of life. That’s critical mass.

And the only path that I know of that is guaranteed to get you there is a slow-boring one because it’s the most tried and true one. There is a reason why we come across many “get rich quick” schemes but never any “get wealthy quick” ones.

Yet behaviorally, the slow-boring path is the hardest to adhere to.

Charles Kinderberger, economic historian and an author of many investment classics, once said that there is nothing so disturbing to one’s well-being and judgment as to see a friend get rich.

And there will always be folks getting richer than you on some of the dumbest things you could have ‘invested’ your money in. Don’t let that take you off the rails away from a well-crafted plan.

And sure, you can strike it rich a million ways but holding on to wealth without a process, without a plan is tough. Because there are a million ways to lose it all.

I am not saying you have to hoard wealth to a point that you forget to live in the now and defer everything to that proverbial future. Because as they say, you can’t go snow-boarding in your nineties.

All I am saying is that there must be a balance between consumption now versus consumption later. That’s consumption smoothing where we tweak and optimize our spending to design a life that has a base level of happiness with occasional spurts of exoticism blended in. Because of course, YOLO.

And forget worrying about what we’ll leave behind for our heirs to inherit. That’s going to be dissipated anyways. I mean we can try but it’s going to be tough because of the human condition and hence the saying ‘shirtsleeves to shirtsleeves in three generations’.

And it makes so much sense. Say you are in the minimalist camp, your kids will absorb all those experiences and maybe implement some or most of them into their own lives. But then that minimalist mindset automatically means wealth accumulation which then gets passed down to your kids. Or at least that’s what most people do.

But then your kids someday have their own kids and now the setup is completely different. Their kids never get to see the struggle. They never experience frugality and choices being made. Life is easy. There is no drive and hence slowly but surely, wealth gets frittered away and the cycle repeats.

So is it any wonder that 70% of wealthy families lose their wealth by the second generation and a stunning 90% by the third¹.

Of course that does not mean you don’t try but many a times, it would be an exercise in futility and it’s good to have that perspective.

So coming back to you, the timeframe to reach critical mass is different for different people. And it’ll come down to two things – your burn rate and your investment returns. Investment returns beyond what’s statistically likely based on the risk-return characteristic of your portfolio are not in your control and neither should you base your financial plan on.

Burn rate is in your control and of course the lower the burn, the sooner you’ll reach critical mass. And one big side benefit of a lower burn rate is that now you are used to living on way less than you could since you’ve designed your life around that. I mean you were able to get to that base level of life satisfaction that your burn buys. And that should be the goal.

So increase the earn, reduce the burn and take the difference and deploy it into a plan that is tailored for you. Do that for some time and critical mass would be within reach far sooner than you realize.

That’s all I have to say. Thank you for reading.

Cover image credit – Joel Santos, Pexels

¹ Chris Taylor. “70% of Rich Families Lose Their Wealth by the Second Generation”, Reuters. June 17, 2015.

But whether it is different or not can only be known in hindsight. But when a majority of investors believe that this time is indeed different and are getting rich of it is when the chasm between asset prices and their underlying value grows. That’s happened in the past and will continue to happen in the future. That’s human nature.

So is this time different? Similarities are aplenty between the current stock market boom, especially in tech, with the Dot-com boom at the turn of the last century. New public listings were seeing euphoric rise in prices then as they are seeing now. Investors were willing to fund anything and everything that moved back then whether a viable business existed or not. Something similar appears to be the case now.

And a viable business of course means not just revenues but profits and cash flows. And sustainable at that.

So though there are a lot of similarities, there are BIG differences.

The price to earnings ratio of the stock market today stands at around 30, about the same as it was during the late 1990s. So the earnings yield of the stock market hence is 3.33% (earnings/price), about the same during both periods.

Now if you had money to invest, did you have viable alternatives to bypass the craziness with the stock market back then? You indeed did.

Back in the day, a 10-year Treasury bond yielded 6.5% so you could have locked in that yield every year for ten straight years. And mortgage rates are tied at the hip with Treasury bond rates so real estate had to yield the same or more. And it did.

No such luck now with yields on that same bond at less than 1%. There is no suitable alternative. Yields are low on pretty much everything and prices are hence, sky high.

One more thing that’s different between now and back then is the sheer size of the market debuts of many businesses going public today versus in the past.

Amazon went public in 1997 at a 438 million dollar valuation, literally a small-cap. Microsoft, a decade before that had its public market debut at $700 million valuation. Apple at a billion.

So public market investors at the time were literally getting in on the ground floor. They were the venture capitalists of the day.

And we know the venture capital business model. Most investments go nowhere with only a tiny fraction of them making up for all the losers. And that is what happened back then. You had to spray your money at many businesses going public at the time to get one Microsoft or Amazon or Netflix. That’s how it works. That’s how it was supposed to work. That was the 1980s and the 1990s.

And then the market crashed. Investors who were happy making money when all was great cried foul. So the politicians intervened to ‘protect’ the mom and pop investors from themselves but in that process, they killed that golden goose of letting investors participate in the growth phase of many of the businesses of today.

Now part of that intervention was justified because of the Enrons and the Worldcoms and the Tycos of the day but I believe that the pendulum swung too far in the other extreme.

But if investors were a little prudent back then and knew how to behave and participate right in the markets, the situation could have been different. And we sure hope the story ends for the better now but it looks less and less likely with each passing day.

And hence going public today means dealing with all the bureaucracy associated with quarterly filings and reporting to ‘protect’ investors. That takes time away from actually running and growing a business so a big hassle for newly formed companies. Plus the inability of investors to think beyond the next quarter doesn’t help either.

So businesses are making their public market debuts a lot later in the cycle than they did in the past. These are big businesses. Many are a decade old enterprises with established brands generating boatloads of revenues. The only thing that is amiss are profits.

So that’s a troubling sign. And valuations are outright outrageous but investors don’t care. No price is too high because this time is…

The only silver lining with owning these newly public businesses is that a lot of the losers that would have existed in their midst in times past have already been weeded out in the private sphere.

So private investors are absorbing a lot of the failures and only the ‘real’ ones are getting to you and me. But then we miss out on the growth phase of many of these businesses so both good and bad. I think it eventually cancels out but the process of going and remaining public needs an overhaul.

So my advice, if you care, to you is this:

• Limit this craziness to a portion of your portfolio that if it all goes to zero, will not disrupt your life. Start today and slice off say 10% of your chunk and go at it. That’s your Vegas money. Don’t add more. You don’t have to do any of it but if you must insist.
• Future returns are going to be low. There is no way that risk-free rates could be zero and yet you continue making double digit returns. That’s theoretically not possible. So don’t get used to this and plan to save more.
• The party will be over at some point. Low interest rates amplify asset volatility and the only side we are getting to see is the positive side of that volatility. The negative side is coming. That’s not to fear though. Just expect it and embrace it by sticking to your plan.
  

Rounding this off with this snapshot of a tweet from Chris Sacca, an early investor in some of the hottest brands around (Twitter, Uber, Instagram). I like him a lot. He means well. And there are many more in this business today who mean well. They are a different crop who care about all stakeholders and for them, making money is just one aspect. That should remain and that’s great.

So that’s that.

Thank you for reading.

Until later.

Cover image credit – Andrey Grushnikov, Pexels

Craig L. Israelsen, professor of all things financial planning at the Brigham Young University likens the art of portfolio construction to making salsa. I mean you can add your own flavor to a recipe but ultimately, the ingredients that constitute a wholesome salsa don’t differ much. And so shouldn’t the ingredients of your portfolio.

The recipe is your portfolio’s asset allocation. There are complex elements to it but inherently, not that complex.

Some of the elements that make up a salsa, say salt for example, may not be very exciting. And they are not supposed to be. They are neutralizers.

A well-designed portfolio should have its own set of neutralizers.

But then we’ve got a world where the only thing that matters is how you compare against the S&P 500 index. At least lately. Or God forbid, the Nasdaq. Talking about Nasdaq…

Comparisons against these indices didn’t happen as much during the decade of the 2000s when indices similar to these sucked wind but they happen now because we forget. We are too busy. We take mental shortcuts instead of thinking deeply about what we own and why.

And since when do we compare salsa to 500 ground-up tomatoes? We have created a misconception around what diversification is. The S&P 500 is a diversified set within an asset class. That’s not true diversification. That’s intra-diversification. It’s depth, not breadth.

And Nasdaq’s worse. Yes, yes, a lot of companies that make up that index will go on to change our world but it’s still mostly a narrow subset of the investible universe. And there are other means to own it.

So getting both breadth and depth is true diversification. A multi-asset portfolio that encompasses a need appropriate allocation is what you want.

A 60-year old’s portfolio should look different than that of a 30-year old.

A 60-year old’s portfolio with a solid pension should also look different than that of a 60-year old’s without a pension.

Back to the S&P 500, this is what you get when you own just it.

So the biggest 25 businesses take up almost 45% of your money. Even in a winner take all kind of an economy, that’s too much concentration in just a few businesses if this is all you’ll do with your money.

And large businesses don’t stay large forever. They become stodgy, bureaucratic and unmanageable and eventually get replaced by smaller, more nimble rivals. It is only a rare breed that can maintain their market power for decades on. A prime example of that process and there are many is General Electric which at one point was the largest market value business in the world but now is a shell of its former self.

The current bunch of the large cap universe could be an exception but history says otherwise. There is always something around the corner that would dislodge the hot ones of today. It might take longer but it’s going to happen.

Plus a portfolio invested only in the S&P 500 index leaves out stalwarts like these and 3,000+ others…

Not a collection that screams of deep value but it is a collection.

So what’s a flavor of depth and breadth? Maybe this…

That’s for domestic equities. The ingredients and the proportions can change based on where you are in life but seems even-keeled and at least pointing in the right direction. You do something similar for international equities. Then you bring in bonds and cash, real estate and alternatives. Now that’s salsa.

On bonds, the last 40 years have been the best 40 years in the history of the fixed-income world. That’s not going to be repeated so caution on what type and duration to own is warranted.

And the portfolio you design should be a function of how much you’ve saved, what you’ll continue to save plus growth in value. Expecting just your portfolio to do the heavy-lifting without a pitch from your savings is not going to cut it in this yield-starved world. Encounter anything that promises that, run.

And last, as Carl Richards, the author of The Behavior Gap says, you can have the best portfolio ever designed in the history of the world and you make one behavioral mistake a decade, you might as well have stuffed all that cash in a mattress.

So don’t.

Thank you for reading.

Until later.

Cover image credit – Karolina Grabowska, Pexels

When outcome is essential and matters more than relationship, use trust, but verify. When relationship matters more than any single outcome, don’t use it. 

So true that. But since there are no relationships to care for when it comes to being a good steward of our money, we should trust little and verify a lot. And that task becomes a lot easier with a bit of intuition and access to data.

So there is this thing called rebalancing and it means exactly as it sounds. Say we start with a 60/40 stock-bond portfolio and over time as the markets evolve, that allocation drifts to say 65/35. If the intent is to maintain a constant allocation, we’d sell the stock component of the portfolio, taking out the excess and buy into the bond portion to bring the allocation back to 60/40. That’s rebalancing.

And it sounds like a great idea. We sell something that has gone up and buy the other that has gone down – a classic buy low, sell high approach. So that’s great. But then I read something along the lines that rebalancing between stocks and bonds works but rebalancing within a category is not ideal or does not work as effectively.

Take stocks as a category for example. You’ll likely own some large company stocks, mid-size company stocks and some small ones. And then you’ll own developed market international stocks and emerging market stocks and so on. Not all of them will move in the same direction all the time. Some will zig while others zag. Or some will zig some while others will zig more and so on. So if you rebalance within a category, you would be theoretically doing the same thing that you ideally would want to do – buy low and sell high.

But now there’s this doubt and we need to get to the bottom of it to make sure all’s okay. So as we would do and as we should do, we test both approaches at once to validate that what we’ve done all along was not inferior to what we should have done.

So we go back to data and test whether an invest & forget approach works better than say rebalancing annually. Ideally we would and should rebalance as often as there is an opportunity to rebalance but let’s just assume we do it once each year. We’ll use data on annual returns for four asset classes to test the two approaches.

• Large company U.S. stocks
• Small company U.S. stocks
• International stocks
• U.S. bonds

We invest $100 in a portfolio comprised of these four asset classes at the start of the entire time period in varying proportions of 10% increments and assess whether rebalancing does what it is supposed to do. A snapshot of different portfolio combinations is shown below.

Each row is one portfolio and with 10% incremental allocation spread across four asset classes means 258 different portfolio combinations we get to try this on.

Starting with year 1, in year 2 in case of the rebalancing approach, we sell whatever has deviated to the upside from the original allocation and buy what has declined to bring the allocation back in line. For the invest & forget approach, we split and invest the original $100 into the allocation we started out with and let the money ride till the end of the period. The end of the period by the way is 2018 and the dataset contains 49 years of data starting in 1970. So we are comparing the ending values of each portfolio at the end of 2018 to test the rebalancing vs. invest & forget approach.

The first thing we should do to get a good feel is to look at how the ending values are distributed between the two options.

So clearly rebalancing works as is evident from a slight right shift of its distribution as compared to invest & forget. The spread is a bit wider though with rebalancing which is not desired but a bigger question is, are we comparing the same portfolios when comparing outcomes between the two? What we should ideally compare is the ending value of portfolio 1 in the invest & forget case with the ending value of portfolio 1 in the rebalanced case, the ending value of portfolio 2 in the invest & forget case with the ending value of portfolio 2 in the rebalanced case and so on.

So that’s what we have done next and this is what we find when we do a portfolio by portfolio comparison of the ending values…

• Out of 258 portfolios, each with a different asset allocation, the ending values of 243 portfolios that were annually rebalanced equaled or outperformed those of the invest & forget ones. So a 94% outperformance rate if the portfolios were rebalanced as compared to invest & forget.
• 79 portfolios out of 258 that were annually rebalanced outperformed invest & forget ones by more than 10%.
• And the ending values of three out of 258 portfolios outperformed invest & forget by more than 25%.

So rebalancing works or at least worked almost all the time. But what if the bond allocation was held constant at say 40%? The original thesis was that rebalancing is more effective between categories (stocks vs. bonds) versus within categories (within stocks or within bonds). So trying that out…

Apparently the same story here with the shift in distribution for the rebalanced case more to the right than for the invest & forget approach. Oh and by the way, because the bond allocation is held constant with only the remaining three asset classes in the stock category allowed to vary, only 60 portfolio combinations are possible.

A portfolio by portfolio comparison of the ending values yields the following results…

• Out of 60 possible portfolios, each with a different asset allocation and a fixed bond allocation, the ending values of 59 portfolios that were annually rebalanced equaled or outperformed those of the invest & forget ones. So a 98% hit rate making the case even stronger for the rebalancing approach.
• 25 portfolios out of 60 that were annually rebalanced outperformed invest & forget ones by more than 10%.
• And one outperformed invest & forget by more than 25%.

So if you had to wager, rebalancing still wins.

What if you owned an all-stock portfolio? Would rebalancing still outperform invest & forget?

Appears to be a yes. And again as before, only 60 portfolio combinations are possible so a portfolio by portfolio comparison yields the following…

• Out of 60 possible all-stock portfolios, the ending values with the rebalanced approach equaled or outperformed invest & forget each and every time. So a 100% hit rate in favor of rebalancing.
• But none of them outperformed by more than 10% so not a big thumping vote for one over the other.

But what if the returns of the past do not repeat in the same sequence? Could the outcomes be different with a different sequence of returns?

To assess that, we sample returns for each asset class randomly and recreate the asset class returns dataset each time and compare the ending portfolio values between the two approaches. And just to make sure that we have at least attempted to try every which way to convincingly make one approach fail over the other, we do this 500 times. The results…

With portfolios constructed out of a combination of the four asset classes (large company U.S. stocks, small company U.S. stocks, international stocks and U.S. bonds)…

So a very strong vote in favor of rebalancing even with randomized returns sequences.

With a 40% constant allocation to U.S. bonds and the allocation to stocks allowed to vary…

Rebalancing wins here as well.

And for the stocks only portfolios (large company U.S. stocks, small company U.S. stocks & international stocks)…

So you’d be crazy to not rebalance your portfolios from time to time.

But here’s a thing. This whole thing is fundamentally based on the fact that mean reversion will always happen. That is, if an investment has deviated from its normal course either on the upside or the downside, it will always revert back to its mean course over the long term.

But what is long term? Ten years, twenty-five years, hundred years? We can only know this in hindsight maybe long after we are dead so that’s one thing to consider.

And what if an investment ceases to exist? Individual companies we know live and die all the time so to guard against that risk, we’d diversify into a sector. Could an entire sector vanish or never, ever revert back to its mean trajectory of growth? Of course.

What about countries? That’s easy, Japan.

The post-war rebuilding which eventually culminated into a real estate led economic boom of the 1980’s Japan was so big and went on for so long that just the fact that it all eventually came crashing down does not quite do enough justice to the sheer scale of that bubble. Edward Chancellor in his book, Devil Take The Hindmost chronicles the reasons for the boom and what led to its eventual implosion.

One of the key drivers for the boom…

Between 1956 and 1986, land prices increased 5,000 percent, while consumer prices merely doubled. During this period, in only one year (1974) did land prices decline. Acting on the belief that land prices would never fall again, Japanese banks provided loans against the collateral of land rather than cash flows.

Land prices will never fall again, wonder where we have heard that before? So the banks lent money just because the value of the land rose. And the more it rose, the more they lent, creating that self-fulfilling feedback loop of ever increasing prices, leveraged to the hilt. Things got so crazy that by 1989,

The grounds of the Imperial Palace in Tokyo were estimated to be worth more than the entire real estate value of California (or Canada, if you preferred).

And the post-crash recovery didn’t quite materialize or hasn’t yet materialized due to structural reasons that are unique to Japan, though there are signs that things might be finally on the mend. But then they have a long way to go.

Back to the rebalancing or not rebalancing question at hand, so if a portfolio design is done not considering the fact that there might not ever be a mean reversion, we are doomed.

And I might have insinuated before that I am strongly in one camp or the other but I am not completely sold on either. So I employ a mix of both. And that’s because I don’t know the future. No one knows the future but try one must with as much supporting research and evidence. And a bit of intuition.

Thank you for reading and persevering through.

Until later.

Cover image credit – Matthew T Rader, Pexels