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A co-worker of mine disclosed today that she moved her entire 401k to cash and bonds last week. She is older than me and has what must be a sizable balance because her reasoning was “I couldn’t stand it anymore, all my contributions for the last year have disappeared! Why did I bother?”

I thought that it was an interesting – albeit dangerous – way of measuring returns. I can see how it can be depressing if you start with $100,000 at the beginning of the year, keep putting away $1,000 every month for a year, and then at the end of year… you still have only $100,000 due to market drops. It can be easy to view it as simply throwing money away. I miss the safety of cash!

But this is dangerous because comparing absolute changes in your entire account to your current contributions would seem to greatly magnify any gains or losses in your account. For example, if you start with $100,000 put in $1,000/month for a year in a bull market, you might end up with $124,000 at the end of the year. You put in $12,000, but your balance grew by $24,000! Feels great, maybe I need more stocks! But in reality this is basically the above scenario in reverse, and nowhere near a 100% return.

This way of framing losses reminded me of the popular behavioral finance book Your Money & Your Brain. Are our brains just wired poorly to deal with the swings of investing?

On the other hand, perhaps this should also serve as a reminder to properly assess your appetite for risk. Going back and forth between lots of stocks and zero stocks is highly unlikely to return in better overall returns. Numerous academic studies have shown that even professional money managers don’t do market timing well at all. Simply picking something in the middle and sticking with it actually turns out better. We can try to use these gloomy times to try and find that balance where we won’t be tempted to go either way in both good times and bad.

Earlier this week I got a very good question from a reader:

Last week I decided to take your advice and invest $4,000 in a Roth IRA. My Roth IRA holds only one fund: Vanguard Target Retirement 2050, which holds 90% stocks and 10% bonds. Unfortunately, my timing was terrible: in a mere 3 days, my initial $4,000 investment has already fallen to $3,800, and there seems to be no end in sight. I keep reading all of these pessimistic forecasts about a looming bear market, so I’m very worried about losing my $4,000 investment.

My question for you is: Am I overreacting, or is there something I should do to protect my investment? I don’t need this money now; I invested it knowing fully well that I wouldn’t reap the benefits of it for another 40+ years. If the market keeps going south, however, I’m worried that I’m going to lose most of my $4,000 investment. Do you think I should try to withdraw my remaining money from the Vanguard 2050 fund and invest it in something less risky? I know that you’re generally opposed to attempts to “time” the markets, but I can’t help feeling foolish for investing $4,000 in a fund containing 90% stocks without taking into account the current market conditions.

I think everyone from time to time will question their investments. Again, I’m not a financial professional, but here is what I call “brotherly advice” – as in it’s the same thing I would tell you if you were my family.

1) There is virtually zero chance you will lose your $4,000. That’s part of the benefit of having a widely diversified mutual fund. An individual company, even a huge company like Enron, MCI Worldcom, or E-Trade has the possibility of going bankrupt and becoming worthless. For a Vanguard Target Retirement fund to go to zero, we’d be in Stone Age 2.0 and your primary concerns would probably be food, shelter, and guns.

2) Remember your time horizon. You chose the 2050 fund, which theoretically means you won’t need to withdraw for 43 years, and it seems like you’re okay with that. So then the question is – do you think you will end up higher or lower than $4,000 in 40 years? Because that’s what matters. If you think it will end up higher, then who cares what it’s worth today, or next week, or even the next decade? If you haven’t already, check out this chart.

3) Stop looking at your account. I’m a money geek, but I only look at my IRA accounts once a month to do my net worth updates. Honest! I have zero clue how I’ve done so far this month.

4) Risk = Reward. I know $200 seems like a big loss now, but really it’s just part of the deal. If there was no ups and downs, there would be no extra gain. No risk = bank savings account. You want the ups and downs! Adjusting risk tolerance is a very tricky thing – people tend to have low risk tolerance when the markets go down, and high risk tolerance when the market is hot. Not good. I think the gradual decreasing of risk provided by the Target Retirement fund is a better way to avoid such conflicts.

If 2050 is truly your time horizon, I say stay put. I could go on and on about the behavioral reasons against market timing and pull fancy stats from historical studies, but the above simple reasons are how I convince myself to step back and keep calm. I’ve lost way more than $200 over the last few months, and I haven’t sold a thing. If I do, I’ll let you know. Don’t hold your breath though. 😉

I feel like my last post about rebalancing wasn’t as thorough as I’d have liked it to be, so here I go again, adding some quick definitions and including a review of several research articles about the subject.

What is Rebalancing?
Let say you examine your risk tolerance and decide to invest in a mixture of 70% stocks and 30% bonds. As the years go by, your portfolio will drift one way or another. You may drop down to 60% stocks or rise up to 90% stocks. The act of rebalancing involves selling or buying shares in order to return to your initial stock/bond ratio of 70%/30%.

Why Rebalance?
Rebalancing is a way to maintain the risk/reward ratio that you have chosen for your investments. In the example above, doing nothing may leave you with a 90% stock/10% bond portfolio, which is much more aggressive than your initial 70%/30% stock/bond mix.

In addition, rebalancing also forces you to buy temporarily under-performing assets and sell over-performing assets (buy low, sell high). This is the exact opposite behavior of what is shown by many investors, which is to buy in when something is hot and over-performing, only to sell when the same investment becomes out of style (buy high, sell low).

However, in taxable accounts, rebalancing will create capital gains/losses and therefore tax consequences. In some brokerage accounts, rebalancing will incur commission costs or trading fees. This is why, if possible, it is a good idea to redirect any new investment deposits in order to try and maintain your target ratios.

How Often Should I Rebalance My Portfolio?
Some people rebalance on a certain time-based schedule – for example, once every 6-months, every year, or every 2 years. Others wait until certain asset classes shift a certain amount away from their desired targets before taking any action. A good source of research articles about which method is optimal can be found at the AltruistFA Reading Room. I’ve been reading through them the past few days, and I’ll try to provide a very general overview of the articles here.

So what is best? You may be surprised by the fact that not only is there no clear agreement on the answer to this question, but many of the articles actually contradict each other! For instance, compare this Journal of Investing article:

Over this period, regular monthly rebalancing returns dominated less active approaches. Should one infer that daily rebalancing is better still? Our data cannot say, but it seems plausible.

with this excerpt from an Efficient Frontier article:

So, what can we conclude from all this? Monthly rebalancing is too frequent. There are small rewards to increasing one’s rebalancing frequency from quarterly up to several years, but this comes at the price of increased portfolio risk.

Eh? I believe that this is because their results vary significantly with the time period chosen and asset classes being used in their back-tested scenarios.

Then there is this paper from Financial Planning magazine, which used the 25 year period from Oct. 1977-Sept. 2002 and a 60% Stock (S&P 500 Index) and 40% Bond (Lehman Bros. Gov’t Index) as the starting/target allocation. Here are the results for various rebalancing frequencies:

The various rebalancing periods showed minimal performance differences, although annual rebalancing held a slight return margin and a higher risk margin.

Because the risk-adjusted performance differences among the portfolios were small, the answer to the question of when to rebalance–monthly, quarterly, semi-annually, or annually–depends mainly on the costs to the investor of rebalancing.

Efficient Frontier’s Bernstein also agreed in the this last respect, stating “The returns differences among various rebalancing strategies are quite small in the long run.”

In the “wait for a significant shift before taking action” camp is author Larry Swedroe, who I think also presents a very reasonable solution. From a WSJ article:

With major holdings like U.S. stocks, foreign stocks and high-quality U.S. bonds, consider rebalancing whenever your fund holdings get five percentage points above or below your targets, suggests Larry Swedroe, research director at Buckingham Asset Management in St. Louis. For instance, if you have 40% earmarked for bonds, you would rebalance if your bonds got above 45% or fell below 35%.

Meanwhile, for smaller positions in sectors like emerging markets and real-estate investment trusts, Mr. Swedroe recommends a 25% trigger. So if you have 5% targeted for emerging-market stocks, you’d rebalance if emerging markets balloon above 6.25% or fall below 3.75%. “You definitely want to be rebalancing, but you don’t want to be doing it too often,” Mr. Swedroe says. “You want to let stocks go up a bit before you sell, but not so much that you lose control of risk.”

Summary
Since it seems that there is no concrete right answer, I think the most important thing is to just make sure you set up some way to rebalance that does not involve any emotions or market timing. Don’t worry about the details, but don’t let your portfolio run off on its own either. I think the subtitle of one of the articles above sums it up quite well… ‘Tis Better To Have Rebalanced Regularly Than Not At All.

I have personally chosen to rebalance annually. This method keeps it simple while still controlling risk and offering potential extra return. If I recall correctly, it is also recommended in Ferri’s book All About Asset Allocation (review).