Investments can be complicated, but they don’t need to be. Investors just need to know their objectives and some intelligible ways to achieve them. Generally, investors want high returns and low risk. Once they achieve suitable exposure to both, rebalancing—maintaining balance among components—keeps investors on a steady course.
High returns usually come from owning stocks. History has shown that over long periods of time, stocks almost always out perform bonds, real estate, and many other investments. Alternatively, stocks are often risky.
Bonds usually produce lower returns, but they tend to be less risky. A portfolio that combines a diversity of stocks and a diversity of bonds is likely to generate good returns with only moderate risk.
The Later Living post, How to Make the Six-Step Investment Model Work Better, showed that a portfolio of two Vanguard index mutual funds supported annual withdrawals of 4% of the initial portfolio for the last 11 years, ending the period 6% higher than at the start. Rebalancing helped produce that success with a buying and selling process that maintained an initial diversification of 50% stocks and 50% bonds (see Appendix for details).
The nifty effect of rebalancing: in small increments, without changing the portfolio’s risk exposure, an investor is living the dream of always buying low and selling high. Each year you sell a few winners—the investments that are relatively high—and buy some losers—the investments that are relatively low. Rebalancing helps investors take advantage of the random qualities of investment returns. Since no one knows how investments may change, investors who rebalance buy low and sell high just enough to keep the portfolio at a predetermined level of risk.
Diversification controls risk. That control can be crucial for retirees who are withdrawing from, rather than adding to, their investments. Risk refers to variability—a more risky investment may go way up or way down, depending on forces in the economy. A less risky one moves up and down, but more slowly or within smaller ranges.
More subtly, investments don’t always vary in the same direction—often, but not always, when stocks decline, bonds rise. This co-variability is important because when two investments vary in opposite directions at one time, combining them in a portfolio will greatly reduce the overall risk.
Without rebalancing, stocks will gradually become more dominant in the portfolio because they usually grow faster. Then if one or two bad years cut stock values in half or more, the total portfolio can suffer badly, especially when combined with annual withdrawals to support retirement living.
By rebalancing annually and thereby limiting the exposure to the volatility of stocks (risk), retirees reduce the chances of watching their portfolio vanish and having to live only on Social Security.
In the Six-Step Investment Model, rebalancing increased returns by about 6%. Without rebalancing, the portfolio of Vanguard mutual funds ended the 11-year period with $99.84; with rebalancing, the value was $106.07. Although not all periods will show that result, it did in the most recent 11-year period.
At the same time, when the stock market dropped 37% in 2008, the whole portfolio lost only 20% because half of it was in bonds, which increased 5%. For turbulent times, the 11-year record of the sample portfolio is a good result.
This Appendix prompts readers through the calculations that support the results reported above.
How to Make the Six-Step Model Work Better showed that a new retiree owning the stipulated portfolio and rebalancing annually would end the 11-year period with 6% more than at the beginning. That result is shown in the table below, with the end value being $106.07.
Going through two rows of the table will show how the calculations work. Row 0 (end of year 2000) shows the data for the initial position—a new retiree has $100 of investments, split evenly between stocks and bonds. Each subsequent row shows a year of results in the retiree’s life. The return data (columns two and four) come from the prospectuses published online for the Vanguard Total Stock Market Index Fund Investor Shares, and the Vanguard Total Bond Market Index Fund Investor Shares.
At the end of year 2001, stocks had declined 11% and bonds rose in value by 8%. The initial $50 in each dropped below $45 for stocks and rose above $54 for bonds. The total portfolio value decreased to $98.73. Then $4 was subtracted to help support the retiree in the upcoming year, and the resulting value was divided in two to reach the stock and bond values at the beginning of the next year ($47.37).
The buying and selling would work like this: At the end of year 1, $6.85 ($54.22 – $47.37) worth of bonds would be sold and $2.85 ($47.37 – $44.52) worth of stocks would be purchased, giving $47.37 in each account and leaving $4 for spending. In so doing, the portfolio is again balanced at half stocks and half bonds.
In 2002, stocks declined by another 21%, reducing the $47.37 stock investment to $37.44. Bonds increased 8%, increasing the $47.37 bond investment to $51.28, giving a total portfolio value of $88.71. Then $4 is again subtracted, and the net of $84.71 is halved to get the bond and stock investments for the next year ($42.36).
The buying and selling work the same. Bonds are again sold—$8.92 ($51.28-$42.36)—and $4.92 ($42.36 – $37.44) of that are used to buy bonds, leaving $4 for consumption.
Repeated year after year, the table shows the movement of an annually rebalanced portfolio for the full period, ending with a final, rounded value of $106.07.
When similar calculations are done without rebalancing, that is, by subtracting $2 from bonds and $2 from stocks each year, the resulting total is $99.84, which is $6.23 below the result with rebalancing.
Readers now have the details of the Six-Step Investment Model for retirees.