Shrinking The Gap, Part 4- Rebalancing

We continue in our series of "Shrinking The Gap".  Today we are going to cover the value added disciplined of rebalancing.  Anyone that has an interest in investing has heard the term rebalancing- the act of bringing a portfolio back to its target weighting in various asset classes.  It typically involves selling the asset classes that have gone up in value and adding to asset classes that have shrunk.  In this way, it is a systematic way to buy low and sell high.  But like many elements of investing it is important to note that it doesn't always work.  In a prior post we talked about the benefits of diversification.  Over time, this strategy tends to be beneficial, but there are certainly periods, like the last five years, where it hasn't paid to diversify (US stocks have handily outperformed almost all asset classes).  In the same vein, rebalancing may not work for periods of time.  In many ways it can be increasingly frustrating.  I have illustrated a time period to show how challenging it can be.  Below are the returns of two portfolios* from the 1990s (12/1989 to 12/1999):

  • 60% US Stocks/40% US bonds (rebalanced quarterly)- 13.90% annual return
  • 60% US Stocks/40% US Bonds (never rebalanced)- 17.82% annual return

For those keeping score at home, that is nearly a 4% higher annualized return by doing nothing over that 10 year period.  If you had $1 million invested you'd have approximately $1.5 million more BY NOT REBALANCING!  So, is this really a good strategy to pursue?  

We think the answer is unequivocally yes.  The main value of rebalancing is not to increase your return, but to control your risk.  During periods of expansion in the stock market, you will find that you are taking money from the most risky assets each year and adding to safe assets.  During periods of contraction, portfolio rebalancing causes you to add to risky areas of the portfolio periodically.  It is during these periods of contraction where most investors get tripped up.  They either do nothing, or worse, get scared and sell at inopportune times (the bottom).  Rebalancing during these periods of growth and contraction is a risk management tool.  It may not work during periods when a certain asset class explodes, but it smooths out returns over longer periods of time.  We have done research to show how rebalancing (60/40 portfolio) during a bear market (and subsequent recovery) can add both return and risk to a portfolio at a time when most investors are questioning whether to stay invested at all (click to make bigger):


Rebalancing takes a degree of discipline that can make even the most committed investor squirm.  The act of selling something that is doing well and adding to asset classes that seem to have no hope just goes against our wiring.  That is why so few do it, and why so few get the benefits of this simple act.

*US Stocks are represented by CRSP 1-10 Index, US Bonds are represented by 5 Year Treasury Bonds

Shrinking The Gap, Part 3- Risk Factors

As we continue in our series on "Shrinking The Gap", we are going to focus on another positive contributor to performance:  exposure to risk factors.  Extensive research has been performed to determine what specific factors have a meaningful impact on both risk and return.  For purposes of this post, we are going to focus on the two that we believe are the most persistent:

  1. Size factor-  small companies outperform large companies
  2. Value factor- value companies outperform growth companies

In 1992, Nobel prize winner Gene Fama and Ken French release groundbreaking research on this topic.  Their findings were significant and have sparked an entire industry of "factor investing" or "smart beta" strategies.  The firm best embracing this concept (and finding the most success) has been Dimensional Fund Advisors.  A chart of the Fama/French research can be found below:

Risk factors

What their research has proved is that small companies and value companies have generated BOTH higher returns and higher risk for investors.  This is true not only in the US, but in other free market economies they were able to obtain data from.  So what does this mean for investors?  First, those who are willing to accept elevated risk levels are able to generate higher returns by tilting their portfolios towards these factors.  This is one way an investor can "close the gap" between their actual return and the market's return.  Second, rather than focusing things that don't matter (which fund is going to outperform, is the market high, which stock should I buy), investors now can concentrate their efforts on factors that will have a real impact on their portfolio's performance.

Shrinking The Gap- Part 2, Portfolio Construction

We are continuing in our series on "Shrinking The Gap".  The "Gap" refers to the difference between the market's return and what investors actually return in their portfolio.  In our first post we discussed the six factors that either positively or negatively impact this gap:

Positive contributors:

  1. Portfolio Construction
  2. Risk Factors
  3. Rebalancing

Negative contributors:

  1. Taxes
  2. Costs
  3. Behavior

In this post we are going to touch on the first positive contributor:  portfolio construction.  There are countless studies that show how much of an impact portfolio construction has on risk and return.  In the study "Determinants of Portfolio Performance" researchers determined that over 90% of the variations in a portfolio's return is the result of the asset allocation.  Factors such as market timing or security selection had almost no impact on returns.  Not because these elements are not important, but because no one has been able to consistently demonstrate skill in these areas.  Portfolio construction is mainly focused on how a portfolio should be allocated.  It is often said that diversification is the only free lunch when investing.  Below is a good example of why this is the case:


Most people believe that you have to take more risk to get a higher return.  This is not always the case.  By constructing a portfolio consisting of non-correlated assets you can find ways to increase your return without taking on significant more risk.  Diversifying out of an entire large cap stock portfolio into more of a global market portfolio, you can see that returns were more than 2% higher per year with almost identical volatility (standard deviation).  In addition, the worst 10 year period shows that the global market portfolio was able to avoid the losses that are inevitably found by concentrating your assets in one area.

Having an appropriate allocation for your risk and return requirements is essential for how you manage your assets.  The above example shows that by constructing a diversified portfolio, you have a much higher probability to "shrink the gap".

Shrinking The Gap

Nearly every investor experiences a gap between what the market returns and what they actually return in their portfolio.  We believe that the shrinking of that gap should be the key focus of investors and their advisors.  This post is the first in a series that is designed to determine what the factors are that lead to the gap's existence and what investors can do to shrink it.  Carl Richards, the NYT blogger, refers to this as the "Behavior Gap", and while behavior is a factor that causes underperformance, it is by no means the only factor causing investors to fall short of the returns they are entitled to.  Below is the graphic we show clients:

Shrinking the Gap

There are things we can do that are additive to portfolio performance.  Diversification, exposure to specific risk factors and how we implement rebalancing are some of the key contributors to adding value.  On the other side there are factors that drag down performance.  Taxes, fees and poor investment behavior may not be entirely avoidable but investors need to have a process on how to minimize their impact on a portfolio.

How much value can you add to your portfolio by shrinking this gap?  Everyone is different, but we believe that 2% per year is attainable for most investors.  What does that mean in dollar terms?  A lot.

For a 50 year old investor with $1 million the difference between 6% and 8% over the next 40 years is over $11 million ($10.285MM vs. $21.724MM).  This series will provide you a playbook on how to shrink the gap and earn what you are entitled to.

Happy 6th Birthday Bull Market!

It was on March 6, 2009 that the S&P 500 hit it's intra day low of 666.  Sitting at 2,077 today, the index has grown over 200% in the last six years.  It seems crazy that anyone could have missed out on those gains, but there have been seemingly legitimate reasons you should have stayed out of the market during the past 6 years.  I've listed a few of the reasons I heard throughout the last five years that made investors skeptical to stay in the market:

  • Balooning US debt and uncontrolled deficit
  • The breakup of the Eurozone (that's been an ongoing theme)
  • US unemployment (underemployment)
  • The Fed manipulating interest rates, printing money and/or propping up the stock market
  • A hard landing in China
  • Russia's invasion and occupation of the Ukraine
  • Rising energy costs
  • Falling energy costs
  • Arab spring
  • Devastating hurricanes
  • Passage of Obamacare
  • Near default on US debt via political showdown

I could take every decade in history and list countless reasons why you shouldn't invest.  But there is only one reason I can think of to stay invested:  human ingenuity.  We are hard wired to make things better.  To solve problems.  Let's pull back further and see how much progress we've made over the past several decades:

  • Between 1990-2010 the percentage of children who died before their fifth birthday dropped by almost half
  • Global life expectancy was 47 in the early 1950s but had risen to 70 by 2010
  • Since 1981 the percentage of the global population living in extreme poverty (less than $1.25 per day) dropped from 41% to 14%
  • The worldwide death rate from war has dropped from 300 per 100,000 during World War 2 to less than 1 in the 21st century
  • GDP per capita in the US grew from $12,597 in 1980 to $53,042 in 2013

There will be another crisis at some point.  The stock market will enter bear market territory in the future.  The point is not to try to avoid these events, but to be able to stay invested throughout them.  Those that can stomach the inevitable volatility will be rewarded for their perserverance.  From 1926 through February 2015, $100 invested in the S&P 500 would have grown to $544,962.  It would have been tough to stay invested those 89 years but the rewards for doing so are obvious. 

Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.