The power of the Rebalance bowlhead99

Points that are very important for new investors to grasp are often hidden away in depths of threads where they go unnoticed by the masses and then the same questions come up again and again. This is only the second thread I've started in the last decade but I did a quick bit of maths earlier and was inspired to post the results. It may be of interest to some.

The problem with emotions

I was reading a thread where someone was invested in an emerging market fund which had 'underperformed the market' by a few percent in 6 months and was wondering what to do. Clearly a short term outcome which shouldn't dictate whether a fund is worth investing in, but you always come across people who are wondering how to handle relative valuation changes (hold? buy more? run screaming for the exit?).

Amongst the ensuing discussion of EM funds there was this "gem":

Just in case that wasn't posted as a tongue in cheek comment about the perils of the OP's short termism, and was actually a serious(ly misguided) view, I've snipped off the poster's name

The long term view

That was then rebutted with a response from Masonic with a 20 year graph showing how Templeton Emerging Markets Investment Trust looked against the S&P total return for 20 years, massively outperforming in some years while being beaten soundly in others of course. You are mad if you ignore EM as a sector IMHO, and I favour active funds in those markets rather than the dumb indexes, but that's for the other thread

Making the point with a graph

I couldn't get Trustnet to give the S&P index figures without fiddling about, so recreated a similar 20 year graph using the basic retail class of a North American fund near the top of the alphabetical list. It's an active fund that has done a bit stronger than the S&P in bull markets (only fair, as TEM has been way better than the average global emerging markets fund). I also added on the FTSE All-Share total return as a third fund to split your money between, together with an RPI line to see what you actually need to beat to preserve real terms capital. Inflation was 76% from Dec 1994 to Dec 2014, it turns out.

So here's the graph and you can see that if you could only invest in one thing, and if you knew the results 20 years ago before they came out, you would invest in the US-focussed fund and bank your 635ish% return, because it's better than getting 'only' 470ish with TEM IT or 'only' 350ish with UK Allshare:

But clearly anyone would be blinkered to just buy one fund in one sector and hold it in the hope that it would be the best in the long run. For a start, you don't know if you might want it back in 10 years instead of 20 years, and different funds all did better in different phases.

Jan '97 to Jan '00, UK beat TEM but was beaten by Axa American. Jan 00 to '03, TEM lost pretty much nothing while AXA lost a fortune and UK gave back half the gains it had made since '95. Then as we go '03 to '07, UK is rising much faster and much more smoothly than US, while TEM outpaces them both. After the credit crunch we see TEM go ballistic '09 to '11, while '11 to '15 it's USA going ballistic with UK in a decent second place and TEM bobbling around and going down a bit.

And if you look at the snapshot data under the graph, you can see that in the last five years to today (March 2015), TEM delivered ZERO percent vs Uk 50% and US 90% respectively, so it must be rubbish, while over ten years it delivered 250% so it must be fantastic...

If you invested £100 in TEM in March 2005, you could take the resulting £350 pile of capital you have today, throw 30% of it in the bin, and still have more money than your neighbour who put his £100 in the American fund in March 2005 and was really enjoying watching it go through the roof in the last 3 years. Yet if you did the investment in 1995 instead of 2005 the American one was better again.

So, if you pick any of these funds you get a wild ride. The UK fund looks the least wild but it's certainly wilder than the inflation line that is a proxy for cash savings. And you can't possibly know which one of the funds will make your neighbour jealous over what time period.

What happens if we buy all of them and rebalance?

I went through the Trustnet graphs just looking at 2-year intervals to break down the 20 years into 10 slices of time with performance data read off the chart. The data will be off a few percent and the errors will compound over the periods but it's accurate enough to make a point.

I want to follow what happens if we take 100k and invest it in the three things evenly. In reality you might want to invest 40:30:20:15:5 or whatever, between more funds, but the principles would be same.

In the first time period from Jan '95 I have two funds go up 40-50% each and one that barely breaks double figures. Overall I am 35% up. I will split my £135k into 3 equal slices of £45k and start the next period with that, at Jan '97. This time the worst fund TEM loses a third of its value while the best one almost doubles! A problem if you have emotions. If you can be dispassionate again, you will simply rebalance your resulting total £183k kitty into three £61k investments and get on with it. You are 'selling high' your American fund and 'buying low' the EM one. The table below shows how it plays out:

So as you can see after we invested our three £61k investments in early 1999, the US one did pretty strongly (over 64% gain again) while the EM one did much better than the previous year (gain rather than loss) but is not matching that performance. Our 'rebalancing' model has taken us to a point at Jan 2001 where we've got a total portfolio of almost £250k. We'll rebalance this again of course, but may feel a bit disappointed: it's not, SO FAR, as good as if we had just let the funds run their own course like in the bottom of the table, and had a bit over £270k.

But the £270k we could have had at that point by being 'hands off' is coming from compounding the crazy US outperformance. We had started out with equal chunks but the only way we could have £270k was by letting the US grow to be twice the size of the UK and have the EM component dwindle from a third to only 12% of the pie.

That unfettered portfolio would have been a disaster going into 2001, because the dotcom bubble had already started to deflate and over the next couple of years you'd see the fallout from the collapse of Enron, Worldcom, not to mention the World Trade Center and the US 'growth' fund lost literally half its money. Watching 160k halve to 80k in the 'untouched' porfolio is a reality check; the rebalanced portfolio only has 80k in total in the US fund going into 2001 and after it loses 40k on it, simply tops it back up again and carries on.

There's no point giving commentary on every column but you get the idea. The interesting end result is that the performance enhancements from restricting your winners and topping up your losers can be significant.

What to hold - everything!

We all know that by holding a mix of assets we reduce volatility because we won't see a 50% loss in a year unless ALL the funds delivered that on average. So diversification is great. But we fear that holding something other than the nirvana of magically picking the top 'overall' fund is going to overly dilute our performance compared to what it would have been if we just got it right all the time, even though we admit to ourselves that it's impossible to be right all the time.

You know that if you pull out of the top fund entirely because it just 'had a good run', you'll be disappointed when they have another good run. So you never know where will be best and you should probably always be everywhere. Of course, this should be tempered by looking at risk and volatility and timescales, and 'equal everything' is not really going to be right for anyone.

The advantage of rebalancing every year or so (every 6 months, every 2 years, whatever) is that by not picking and holding the winner forever while the others dwindle, we are always able to go into the 'good times' for each fund with a decent amount of capital for that fund which is about to surge or resurge.

If you initially thought 33% was right for emerging markets and then they do a bit badly (compared to the part of the world that is enjoying a dotcom bubble), there is no point giving up on them right before the world goes through a resources boom. In other words, if your were satisfied that EM exposure at one third is the right long long long term decision, you will be pretty annoyed if your greediness chasing a dotcom bubble means you only have one eighth of your portfolio in EMs when a change of fortunes starts giving the region a 70%,80%,180% annual return.

"OK nice in theory, but someone on here (trying to sound like an expert) said 'diworsification' - they said I'm still compromising if I hold those 'worse' performers alongside my good fund."

Yes - if all the funds are correlated with each other, and two of them simply track the better one with lower returns, always moving the same direction at similar times but adding up to a worse average result, you're right it's a worse result. You are wasting your money if you spread it thinly into funds that move the same direction at the same time with worse profits.

But if you are looking at different asset classes, different regions, industry sectors, you'll find that they each have their day in the sun, their 15 minutes of fame. Uncorrelated assets will each have something to bring to the table that can be enough to retire earlier; importantly they reduce "risk of ruin" - the volatility that lets you go bust due to a problem in one big-bet sector that is too much to recover from.

This post is too long. Wrap it up.

OK I'll try. What was my point? Ah yes, the best fund of the three, the American Growth would have turned £33k into about £245k. Awesome. With a crystal ball, you're wasting your time with the second-placed EM fund if you knew it was only going to deliver £192k, or that the UK fund was only going to give £150k.

But you don't have a crystal ball so you can't know the American one will be the best, you just hope that it is, if you picked it. And even if it is the star, there will always be some points it would not be the best of the three. During those worse times, what you gave up in the good years through 'compromise' gets paid back to you as a reward for keeping the faith with the others.

By picking up useful elements of the EM growth curve AND the dotcom booms AND the QE tidal wave across your diverse portfolio, you can find that you easily afford the dotcom bust and the credit crunch and the resource crash that hit different bits of your portfolio.

We can illustrate with a friendly graph below if the numbers on the spreadsheet are too small to look at.

You can see the American fund was the place to be at the very start and at the end of the 20 year period (and overall) with the EM fund doing very well at some points in the middle. The UK fund spent a lot of time "mid table" or bottom where it finished overall, so perhaps you could just drop it, except you can't drop it because you would be called an idiot for having all your money in North America and Emerging Markets and nothing domestically.

But what of our rebalanced pot? How much is "one third of the overall pie" when the pie keeps getting its ingredients rebalanced?

The answer is it's quite a lot. Because it turns out, there is more than one way to bake.

You don't have to find just one fund that takes it returns and reinvests them in itself so that it soars and then crashes when it all goes wrong. Taking out a part of the good growth from one or two funds and then investing the proceeds in one or two other funds is still a form of compounding. So when the EM funds flatline or drop like a stone, or the US market tanks because it was getting too drunk at its own party, you don't actually give back all the last x years of growth - because your money is not all in the basket that's sinking. You might only ever have one fund doing really badly and you're often getting decent performance elsewhere (or at least, lower losses) to lower your overall volatility.

The conclusion

As a result, the average £33k initially invested and reinvested, using the rebalance program, grew to a very similar ~£243k that it would have grown into if you just put it into the top fund and left it.

You could have gone all in the US with no security against unforseen circumstances and had 3 x £245k = £735k

Or you could have done the rebalancing thing and got ~£243k, ~£243k, ~£243k = £729k. Very nearly as good!

If you had split the cash but taken the approach of leaving the three pots alone you would have come back to get ~£245k, ~£192k and ~£150k = £587k;

So the active work to rebalance the pots has delivered 24% more money than leaving it - about 1% a year extra compound return. And the 'compromise' to get a broader exposure and insurance against unforseen circumstances in the top two funds by always having a third of your money in the boring UK fund seems to have cost very little.

When do I rebalance - 1 January every two years is a bit strange?

I just picked the dates as that's where the ticks were on the Trustnet chart and couldn't be bothered with more frequent data.

Obviously the idea of jumping off a bubble at its highest point and landing at he start of the next one sounds great but is not going to work out for you in practice if you don't know when to jump. The first step is to recognise that you can't know when to jump.

Rebalancing back to a fixed percentage allocation across asset classes or fund types is something that helps you out with the timing of the jump, because while it will never be perfect, you are naturally exiting something at a high price relative to the others and you are buying into something at a low price relative to the others. And the closer you are to the optimum timing, the more profit (or less losses) you make.

By getting it right, it would certainly be possible to make more money from rebalancing across three funds than you could make from investing in any one of those three funds. Powerful stuff. A better balance of exposure to risk without sacrificing performance whatsoever. I haven't cherry-picked any data to make it work in this example, these are just the numbers that came out.

This is not to say that a rebalance program is always going to be as good as blindly chasing the best possible fund and getting lucky that it stays the best possible fund. And there would be date ranges or fund mixes that would be less friendly to rebalancing, particularly if the funds' performances are highly correlated.

And sometimes you could throw in more frequent rebalancing to gain (e.g. selling some TEM in Jan 08 rather than waiting for Jan 09 to come around), but in other times rebalancing daily or weekly or 6-monthly out of a great rise can cost you more in missed compound returns than the alternative of leaving it until you have a really substantial gain or until it's been a decent interval since your last one.

Typically once a year is good enough if you are properly investing for the long term, and in the meantime, obviously if there are dividends generated or new ongoing contributions from your salary, these can be used to 'top up' holdings that have fallen to bring them back to their target percentages without actively needing to sell something first.

Anyway, that's more than enough from me, have fun with your investments...

Great post. Hindsight is a wonderful investment tool. As far as the investment industry goes rebalancing is a way of creating churn and therefore fees. Personally I prefer to use the income generated from investments plus new money to "rebalance" my portfolio. Though I only use funds as a way of investing in less mainstream areas. As I have no desire to pay any costs unnecessarily just for holding investments that I can buy directly off the shelf.

My only sales in 2014 were Tesco's and Thalassa. Tesco's because I had concerns early in the year ( got this one right) and Thalassa was my dud (cashing out at 75% loss). Otherwise many of my holdings that are showing negatively. I've actually topped up with further purchases as the fundamentals of the underlying business are sound. When you follow shares daily. Surprising how volatile prices actually are. How often there's an buying opportunity. A single % here or there isn't much. Over time the differential compounds.

If that is the quality of your threads... I personally wish you would start a few more!

One question... Whilst you could "passively" balance via new money... Does that offer any benefits or issues compared to a more active selling? Would that influence the timing/ scheduling of rebalancing?


One question... Whilst you could "passively" balance via new money... Does that offer any benefits or issues compared to a more active selling? Would that influence the timing/ scheduling of rebalancing?
Originally posted by Jsscmm

If you are drip-feeding from income, then I think there is a strong case for passively rebalancing and this is all you generally need to do until your portfolio reaches a certain size. It seems to beat investing fixed percentages of your money into a selection of funds each month, and it should since rebalancing passively involves buying only the things that are out of favour in the short term.

I've also been inspired by the other thread to run some rebalancing simulations for a lump sum portfolio over differing periods, it seems that in a couple of different scenarios infrequent (every 2 years) rebalancing beats frequent rebalancing (every 1 year or less). It's quite difficult to draw any meaningful conclusions without a larger data set and a lot more time, but it does make me wonder whether these multi-asset funds that rebalance quarterly (or even more frequently) are missing a trick.

Personally, I actively rebalance when a fund has drifted from its target allocation by more than 25% (e.g. if the target allocation was 20%, then I would rebalance if it grew to be >25% or shrank to less than <20%) and passively rebalance whenever I invest new money. No idea how this sort of strategy would perform against the bi-annual rebalancing scheme above - perhaps I should run those numbers...

There's a whole series of articles on the Monevator site about rebalancing. It seems to be a great topic to dive into if you have a lot of time on your hands.

What about share overlap though? Some of my funds have overlap in the same shares, not very highly (under 2% in all cases). Is it essential to avoid overlap?


What about share overlap though? Some of my funds have overlap in the same shares, not very highly (under 2% in all cases). Is it essential to avoid overlap?
Originally posted by KrytenIceCubeHead

I'd only really see it as a potential problem if it meant that an individual company made up a significant part of your portfolio. If you were invested directly in shares, then you might go with the general advice that 20-30 carefully chosen shares would give you plenty of diversification. That would mean that your largest holdings are likely to be in excess of 5% of your portfolio. I would be surprised if a balanced portfolio of several funds, even with significant overlap, would give you more than 2% exposure to any single company. I generally make sure I have a good spread across industry and sector and leave it at that.


I've also been inspired by the other thread to run some rebalancing simulations for a lump sum portfolio over differing periods, it seems that in a couple of different scenarios infrequent (every 2 years) rebalancing beats frequent rebalancing (every 1 year or less). It's quite difficult to draw any meaningful conclusions without a larger data set and a lot more time, but it does make me wonder whether these multi-asset funds that rebalance quarterly (or even more frequently) are missing a trick.
Originally posted by masonic

Unsurprisingly, a lot of people have run a lot of simulations on this. There are many threads on e.g. the Bogleheads forum discussing the benefits or otherwise of rebalancing. One thread to get you started:

The basic conclusion around returns is that --- shock! --- for a given period and a given asset allocation, there is an optimal rebalancing strategy in hindsight, and that the particular optimal rebalancing strategy varies depending on the period and the asset allocation. There does not appear to be any reason to believe that one strategy is intrinsically better than another. But if we believe that long-run returns are somewhat correlated with short-term volatility, then rebalancing provides a way to keep your risk exposure steady without sacrificing return.

Bowlhead, I have to admit to not reading all of your post as I'm up early tomorrow to fit a kitchen in our BTL but from what I have read, I doff my cap to you Sir.

Will read in more detail tomorrow.

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