Nerd Alert

Published On: July 11, 2019

Written by: Ben Atwater and Matt Malick

On July 4^th Netflix released Season 3 of their hit show Stranger Things, a light horror and science fiction series about a group of childhood friends and their adult compatriots who battle supernatural events to save the fictional town of Hawkins, Indiana (and the world). 

Also, over the holiday weekend, a new Vanguard whitepaper on rebalancing came to our attention.

Amidst what were likely other nerdish endeavors, we devoured the series and the whitepaper. 

We mention both in this space because they each got us thinking about long-term economic cycles.  Namely, how radically things change, but also how long it takes for radical change to occur. 

Stranger Things Season 3 takes place in 1985. Much of the show’s action is centered at the Starcourt Mall, which is brand new and bustling with such stores as Radio Shack, Sam Goodie, a jazzercise studio, etc.  The downtown of Hawkins is dying while the new mall is thriving. 

Fast forward to 2019 and malls resembling Starcourt are dead or on life support as downtowns stage a relative renaissance.  The referenced stores and even the exercise trend (jazzercise) are long gone.  Like indoor malls, everything comes and goes, and it tends to do so in an unpredictable fashion.  Some things last longer than others, but few things are absolutely enduring. 

In the world of investing, disciplined rebalancing allows us, as portfolio managers, to accept that no trend goes on indefinitely, but to also acknowledge that we have no idea when a trend will reverse. 

Simply put, rebalancing is bringing an account back to its long-term allocation.  For instance, we might have a client invested 70% in equities and 30% in fixed income based on our retirement projections and their long-term goals.  If the stock market is booming, the client’s allocation may increase to 75% equities, whereby we’d rebalance by selling about 5% of the equities and reinvesting this money in fixed income to get the client back to their 70% stock / 30% bond allocation.  The reverse also happens when the stock market falls dramatically, leaving the portfolio underweight stocks and we’d need to take bond money and use it to purchase stocks. 

Vanguard’s whitepaper identifies three best practices around rebalancing.  Luckily, we’ve been incorporating all three for more than a decade. 

First, rebalancing is not meant to increase return, rather it is to manage risk and emotion.  Rebalancing, historically, does not increase your gross return, all things being equal, but it does improve your risk-adjusted return.  In other words, rebalancing increases return per unit of risk rather than gross return.  The idea of rebalancing is to make the risk and emotion of investing less damaging to your long-term goals.  Rebalancing tends to hurt your returns in a bull market because you are selling stocks as they continue to go up.  Conversely, rebalancing tends to help your returns coming out of a bear market because you were buying stocks when they were depressed. 

Second, effective rebalancing requires a “trigger.” This is a very important part of our discipline.  The main triggers we use are account cash flows (additions and withdrawals), income (dividends and interest), bond maturities and various forms of internal reporting.  In our view, for balanced accounts, we see the bond maturities as being an incredibly important component.  We believe that by using individual laddered bond portfolios, we create a system of “triggering events,” which are the maturity dates of these laddered bonds.  In our view, we own bonds for stability and for rebalancing opportunities, not because of the potential long-term return bonds offer.  Vanguard is very clear that “no one rebalancing strategy is dominant.”  This means that it doesn’t matter when you rebalance (monthly, quarterly, annually, etc.), rather it only matters that you do rebalance and that you do it systematically. 

Third, rebalancing only works if you minimize the transaction and tax costs of rebalancing.  We take great exception to portfolios we see that are regularly rebalanced by a computer because these rebalance programs tend to ignore tax and transaction costs.  Using individual stocks, bonds and the occasional index fund, we have enormous control over the tax implications of our rebalancing.  For some clients, we rebalance in their relationships by looking to accounts that carry no tax impact, like IRAs.  We’re extremely tax-conscious in our rebalancing because we individually manage every account and we can be incredibly careful about capital gains and transaction costs.  This is highly unique. 

The investment and economic environment changes unpredictably, but with a disciplined approach to rebalancing where we acknowledge the risk-adjusted return benefits, act on appropriate “triggers,” and manage the costs, rebalancing will make it more likely clients stay the course and reach their long-term objectives.