More on the Art and Science of Re-balancing

Last week we took a look at Garry and Vivian to see whether there was a difference in managing a portfolio through the buy and hold strategy versus a rebalancing strategy. Most of the time, rebalancing will come out ahead as the superior management strategy.

Garry and Vivian were fortunate to have a significant lump sum of money to invest. Many people are not in the same boat and instead find themselves investing a little bit each and every year.

This week, I wanted to use a different example illustrating different strategies to managing a portfolio if you are in the accumulation phase and investing money every year. This week, we will look at four brothers Sam, Chase, Ernie and Jake.

The four brothers

Let’s assume they each have $10,000 to invest each and every year from 1990 to the end of 2003. For simplicity sake, they diversify into 5 different asset classes: Cash, global equities, Canadian equities, income trusts and bonds. Let’s further assume that they take an unsophisticated approach to diversification and simply divide the portfolio by 5. There is $2000 invested into each of the 5 asset classes. Finally, let’s say the four brothers buy the exact same investments.

After the first year, all four brothers have the exact same outcome and their portfolios are worth only $9838 as the global and Canadian Markets had dismal performance. Now, for the second year, the boys all take a different strategy to managing the portfolios:

  • Sam, the do it again man, decides to stick with the original plan and invest the $10,000 into the same investments in the same proportion as the first year. This means, he puts in $2000 into each of the 5 asset classes every year no matter what happens the previous year.
  • Chase on the other hand decides that he is going to invest the $10,000 into the investment that did the best. In 1990, that was surprisingly cash so Chase’s entire $10,000 went into cash the second year. In fact, every year, Chase decides he will continue to buy his best performing investment.
  • Ernie was the total opposite to Chase in everything in life. Investing was going to be no exception. Ernie decided that rather than buying the best performing investment in the portfolio, he was going to buy the big loser of the year. In 1990, the big loser was the global equities with a -16.4% loss. Ernie continues to chase the loser year after year.
  • Finally, Jake decided to take a fourth and different strategy from the other brothers. Jake decides to rebalance the portfolio to the same mix as the original. For example after the first year, Jake still invests the $10,000 into all 5 different asset classes but the amount he invests into each asset class depends on how much is needed to bring it back to the original mix. Specifically, in the second year, Jake invests the $10,000 as follows:
    • Cash $1749.60
    • Global equity $2295.60
    • Income trust $1869.60
    • Canadian equity $2263.60
    • Bond $1821.60

Essentially, his rebalancing strategy is to buy more of the asset classes that performed poorly and buy less of the asset classes that performed well.

How did the brothers fare?

This week, the differences between the brothers are much more staggering. After 13 years of investing $10,000 per year, Chase using the chase the winners strategy, ended up with the least amount of money. Chase wound up with $257,601.56 equating a 7.9% compound annual return.

Next was Ernie with the chase the losers strategy. Ernie ended up with $262,620.21 after 13 years and a 8.2% compound annual return.

Sam found himself with $271,560 beating out both Chase and Ernie.

Not surprisingly, the rebalancing strategy came out on top but only marginally over Sam. Jake wound up with $275,901.90 or an 8.8% compound annual return.

The bottom line

Whether you are investing one lump sum of money or whether you are investing more frequently over time, rebalancing is a strategy that ultimately adds value over time. The great part of rebalancing is it is not hard to do from an investment perspective. However, experience has shown that is it very difficult to do from an emotional perspective. Rebalancing tries to get you to sell your winners and buy your loses which is something very difficult for most investors to practice. The bottom line is to stay disciplined and use rebalancing to overcome emotion. In the end, you will reap the rewards with this discipline.

Written by Jim Yih

Jim Yih is a Fee Only Advisor, Best Selling Author, and Financial Speaker on wealth, retirement and personal finance. Currently, Jim specializes in putting Financial Education programs into the workplace.For more information you can follow him on Twitter @JimYih or visit his other websites Group Benefits Online and Advisor Think Box.

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