Author Topic: paradox of balance  (Read 4953 times)

lano

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paradox of balance
« on: May 23, 2014, 11:50:15 PM »
Index fund investing is based on the efficient market hypothesis. 

The idea is: The market is efficient, all current information, risk, and expected earnings are reflected in the price of a security.

As such, there is "no point" in trying to pick any one security.

For whatever reason, holding all US stock securities is not "enough."  A person should also hold some combination of all US stocks, large quantity of US Bonds, and all International Stocks.

Let's assume that the balance between the three is 34, 33, and 33 respectively.  This gives the person a risk preference that he or she likes.

If the prices change, the ratio of the three will fall out of balance, and must be "rebalanced."

Here is the paradox question:

How does one reconcile the foundation of index investing with rebalancing?   Isn't rebalancing really just a purchase of a subset of "all" the securities?  And aren't you now just buying one asset at the expense of others because you perceive it to be cheaper? Should you not just instead continue to purchase all three assets in the same ratio as you originally decided upon?

What am I missing?

Let's assume that US Stocks crash and are now out of balance in your portfolio.  Let's assume that the market gives US Stocks a lower price because it is less certain of the future earnings growth potential of US companies.

The market now considers US stocks more risky. If you then buy more US stocks aren't you increasing the "risk" that you originally decided to main?


« Last Edit: May 23, 2014, 11:58:15 PM by lano »

marty998

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Re: paradox of balance
« Reply #1 on: May 24, 2014, 06:36:47 AM »
It's just your personal preference to have the same % asset allocation of each. Essentially what you believing by wanting all 3 asset classes in the same ratio is that they are all the same and that when one goes down you think it is mis-priced and you buy more.

Someone else will explain it better than me, but basically there's a small risk that you keep buying into a shit asset class, in the vain hope that rebalancing will come good eventually, whilst not realising that the asset class is going to zero because of war, famine, pestilence etc.

Ok maybe not that extreme but it supports the assertion.

Jack

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Re: paradox of balance
« Reply #2 on: May 24, 2014, 09:05:05 AM »
I think people who use index investing like this believe in the efficient market hypothesis within an asset class (i.e., that it's not possible to know which large-cap US stocks will perform best), but not necessarily between asset classes (i.e., that it is possible to know that stocks will have higher return than bonds in the long run) or between markets (i.e., that it's possible to know that US stocks will outperform international stocks or vice-versa due to non-market factors like government regulation).

Someone else will explain it better than me, but basically there's a small risk that you keep buying into a shit asset class, in the vain hope that rebalancing will come good eventually, whilst not realising that the asset class is going to zero because of war, famine, pestilence etc.

Individual businesses can fail and individual bond issuers can default, but I think most people believe that it's not possible for an entire asset class (if defined broadly enough) to get wiped out. Maybe it's possible at the country level (which is why Russian ETFs are considered risky), but if it happens at the world level or to your home country, you're pretty much screwed anyway (the only worthwhile "investments" at that point would be weapons, canned food, and defensible shelter).

lano

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Re: paradox of balance
« Reply #3 on: May 24, 2014, 09:57:25 AM »
It's just your personal preference to have the same % asset allocation of each. Essentially what you believing by wanting all 3 asset classes in the same ratio is that they are all the same and that when one goes down you think it is mis-priced and you buy more.

Someone else will explain it better than me, but basically there's a small risk that you keep buying into a shit asset class, in the vain hope that rebalancing will come good eventually, whilst not realising that the asset class is going to zero because of war, famine, pestilence etc.

Ok maybe not that extreme but it supports the assertion.

A person buys into the notion of index funds, and then buys the index funds based on the idea that mispricings do not occur.

A person then rebalances his or her portfolio based on the idea that mispricings do occur?


KingCoin

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Re: paradox of balance
« Reply #4 on: May 24, 2014, 10:11:47 AM »
Re-balancing isn't really about market timing or buying assets when they're "cheap".  It's about maintaining a diversified portfolio with acceptable risk/return characteristics. It easy to imagine a scenario where, after a number of years of rallying, stocks comprise 90% of your initially balanced portfolio. Unless your goal is for your portfolio to become more and more risky over time, why would you not re-balance?

You bring up an interesting point about using prevailing risk characteristics in the market to determine allocation. You could imagine a scenario where you use volatility indicators (perhaps VIX or trailing 100 day realized vol) to determine risk characteristics of a portfolio (beyond long term historical asset characteristics). From a practical standpoint however, this would mean reducing equity exposure when the sky is falling and increasing it when the world seems like a low risk place. This seems like a recipe for getting massively whipsawed,selling equity low and buying high.

butchmonkey

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Re: paradox of balance
« Reply #5 on: May 24, 2014, 10:20:07 AM »
I think you are conflating two issues here. The efficient market hypothesis and asset allocation strategies.

The efficient market hypothesis states that The market efficiently prices securities at any one given time. So trying to take advantage of mispricings is generally futile, especially when the costs of transactions are taken into account.

Asset allocation is a different animal. An investor chooses his portfolio, particularly percentage of stocks versus bonds, based on his risk tolerance.

So in your example, when stocks collapse, your asset allocation becomes out of balance with your own individual risk tolerance. (Your portfolio became too conservative because of changes in market pricing.)

You rebalance in order to make your portfolio consistent with your own risk tolerance.

The other reason to rebalance is that this encourages you to buy low and sell high, and most assets reverts to their mean. There's plenty of evidence that when asset classes are cheap relative to their historical norms they will over perform in the long term.

Hope that helps.


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LalsConstant

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Re: paradox of balance
« Reply #6 on: May 24, 2014, 10:42:56 AM »
Indexing is not based on efficiency theory.  Indexing is agnostic to such a theoretical efficiency.  There have been any number of papers and occasionally an article or webpage over this on this over the years, I just found one example with 20 seconds of Google.

Quote
So the success of passive approaches does not depend on markets being efficient or otherwise, it has nothing at all to do with stocks being correctly priced and everything to do with the fact that markets are zero-sum in nature and costs are the only factor that influences the return, compared to the market, of all investors as a group.

http://www.travismorien.com/inefficientindexing.htm

No idea who Travis Morien is, but this page references some of the general reasons why it doesn't matter if the market is efficient or not.

All that said, I've come to believe rebalancing is really just a methodical, big picture way to sort of "actively" trade without any kind of emotion, using simple to understand criteria.

rmendpara

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Re: paradox of balance
« Reply #7 on: May 24, 2014, 01:24:42 PM »
Index fund investing is based on the efficient market hypothesis. 

The idea is: The market is efficient, all current information, risk, and expected earnings are reflected in the price of a security.

As such, there is "no point" in trying to pick any one security.

For whatever reason, holding all US stock securities is not "enough."  A person should also hold some combination of all US stocks, large quantity of US Bonds, and all International Stocks.

Let's assume that the balance between the three is 34, 33, and 33 respectively.  This gives the person a risk preference that he or she likes.

If the prices change, the ratio of the three will fall out of balance, and must be "rebalanced."

Here is the paradox question:

How does one reconcile the foundation of index investing with rebalancing?   Isn't rebalancing really just a purchase of a subset of "all" the securities?  And aren't you now just buying one asset at the expense of others because you perceive it to be cheaper? Should you not just instead continue to purchase all three assets in the same ratio as you originally decided upon?

What am I missing?

Let's assume that US Stocks crash and are now out of balance in your portfolio.  Let's assume that the market gives US Stocks a lower price because it is less certain of the future earnings growth potential of US companies.

The market now considers US stocks more risky. If you then buy more US stocks aren't you increasing the "risk" that you originally decided to main?

Agreed with others, you're confusing theories. Efficient market hypothesis assumes that all available information is priced into the current value (e.g. investors understand there is more risk in international stocks than US stocks, so overall there will be a higher valuation of US stocks as a whole compared to intl stocks).

Rebalancing has more to do with being a disciplined investor in that it forces you to take (some) gains from assets that appreciate, and put the gains to work in an asset class/sector that is (relatively) undervalued.


KingCoin

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Re: paradox of balance
« Reply #8 on: May 24, 2014, 06:22:19 PM »
Rebalancing has more to do with being a disciplined investor in that it forces you to take (some) gains from assets that appreciate, and put the gains to work in an asset class/sector that is (relatively) undervalued.

I disagree that this is the point of rebalancing. It's not about "taking gains" or investing in "undervalued" assets. For instance, is rotating stocks into bonds right now really investing in a undervalued class? I dunno. If we knew what was undervalued simply by determing what has recently under or outperformed, investing would be easy.

The point of rebalancing is to maintain a diversified portfolio with desired risk/return characteristics.

lano

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Re: paradox of balance
« Reply #9 on: May 25, 2014, 09:39:24 AM »

"...The point of rebalancing is to maintain a diversified portfolio with desired risk/return characteristics."

But isn't risk a part of the price. 

If an asset goes up in price it might be because it is deemed much less risky -- the future cashflows are much more certain.

Likewise in opposite direction for an asset with a declining price.

If you rebalance are't you messing up the risk/ return characteristic even further then before you rebalanced?




matchewed

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Re: paradox of balance
« Reply #10 on: May 25, 2014, 09:58:43 AM »

"...The point of rebalancing is to maintain a diversified portfolio with desired risk/return characteristics."

But isn't risk a part of the price. 

If an asset goes up in price it might be because it is deemed much less risky -- the future cashflows are much more certain.

Likewise in opposite direction for an asset with a declining price.

If you rebalance are't you messing up the risk/ return characteristic even further then before you rebalanced?

You're viewing it very short term with that mindset. Over the long term an AA with an 80/20 split of equities/bonds will have a historical return +/- some variation, same with a 90/10 or a 60/40. Each one will have a slightly difference performance and slightly different risk characteristic over the long timeline. In the short time frame you're correct that no one can really determine what an asset will do tomorrow, assuming because it went up it will go up or that because it went up it is less risky is the hallmark of bubbles. We have a solid economical framework that encourages the growth of assets over the long term. Trying to chase the short term mindset will lead to mistakes and can damage your portfolio.

Essentially you quoted KingCoin's last part without reading his first part. -
If we knew what was undervalued simply by determing what has recently under or outperformed, investing would be easy.

Real life shows that we have a difficult time determining what will perform in the future. Most of us can't. Rebalancing is about maintaining an Asset Allocation that you are comfortable with the risk and knowledgeable about the potential returns.

lano

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Re: paradox of balance
« Reply #11 on: May 25, 2014, 04:40:10 PM »
I have read both statements.  Both say the same thing. 

I don't see what long term versus short term has to do here.  I never mentioned those terms.  My question would apply to first rebalancing transaction just as it would apply to the next fifty.

Here is my question again and some answers given:

Given that the initial decision to invest in an index fund is based on the idea that current prices of all securities reflect all available information, then on what logic, theory, or idea does one base rebalancing?

Here are some answers in the thread:

1.  Index investing is not based on the efficient market hypothesis. 

While many here might disagree with this answer, it is nevertheless an answer.   My question assumed the efficient market hyposessis to be true -- if this is not true then there is no point in asking further questions about index investing and rebalancing with in the framework of the efficient market. 

However this does open a lot more questions.  The main one being: why invest in an index fund in the first place?


2.   The second answer that I saw was that "asset allocation is something different"

a: "Asset allocation is a different animal. An investor chooses his portfolio, particularly percentage of stocks versus bonds, based on his risk tolerance."

b: "Re-balancing isn't really about market timing or buying assets when they're "cheap".  It's about maintaining a diversified portfolio with acceptable risk/return characteristics."

The main phrases being risk tolerance and risk characteristics. 

But risk is just a variable in the price of a security.   And when you rebalance, under the efficient market hypothesis, you actually move further away from your risk tolerance and characteristic. 

One other way to look at the whole situation is this:

When you start investing you make your first transaction of buy and sell orders.

Rebalancing is every subsequent transaction after.   Surely then, rebalancing transactions are much more important as they are a much larger part of capital most people will invest.

Don't we owe it to ourselves to have a clear and logical understanding about most of the capital that we plant to invest?


 







rmendpara

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Re: paradox of balance
« Reply #12 on: May 25, 2014, 06:27:53 PM »
I have read both statements.  Both say the same thing. 

I don't see what long term versus short term has to do here.  I never mentioned those terms.  My question would apply to first rebalancing transaction just as it would apply to the next fifty.

Here is my question again and some answers given:

Given that the initial decision to invest in an index fund is based on the idea that current prices of all securities reflect all available information, then on what logic, theory, or idea does one base rebalancing?

Here are some answers in the thread:

1.  Index investing is not based on the efficient market hypothesis. 

While many here might disagree with this answer, it is nevertheless an answer.   My question assumed the efficient market hyposessis to be true -- if this is not true then there is no point in asking further questions about index investing and rebalancing with in the framework of the efficient market. 

However this does open a lot more questions.  The main one being: why invest in an index fund in the first place?


2.   The second answer that I saw was that "asset allocation is something different"

a: "Asset allocation is a different animal. An investor chooses his portfolio, particularly percentage of stocks versus bonds, based on his risk tolerance."

b: "Re-balancing isn't really about market timing or buying assets when they're "cheap".  It's about maintaining a diversified portfolio with acceptable risk/return characteristics."

The main phrases being risk tolerance and risk characteristics. 

But risk is just a variable in the price of a security.   And when you rebalance, under the efficient market hypothesis, you actually move further away from your risk tolerance and characteristic. 

One other way to look at the whole situation is this:

When you start investing you make your first transaction of buy and sell orders.

Rebalancing is every subsequent transaction after.   Surely then, rebalancing transactions are much more important as they are a much larger part of capital most people will invest.

Don't we owe it to ourselves to have a clear and logical understanding about most of the capital that we plant to invest?


 

You are asking two different questions. Q1: Market efficiency/security prices. Q2: Index investing.

Markets are not efficient. Embrace it. If they were, hedge funds would not exist, and neither would private equity firms. They both exist.

The way you can think about market efficiency and index investing is this: you disagree with "market consensus".

Example: In the second half of 2013, the market punished REITs because of the fear/expectation of interest rate increases and the effect rising rates would have on REIT profits.

Point #1: If you disagree with the reasoning for the pullback in REITs, you could buy in at a lower price. Same goes for any other situation. If it's clear why the market is driving up/down the price of some security, and if you disagree on the reasoning, you can do the opposite. This does not violate market efficiency.

Point #2: Index investing is the easiest way to get exposure to a certain asset class/sector/etc. Let's say you are bullish on Industrials, but haven't done the research to pick out 5 stocks you want OR don't think any particular names will outperform the broader group. You can buy an ETF/mutual fund/index fund that holds many Industrials, without having to go through the trouble (and additional risk) of specific stocks.

"Don't we owe it to ourselves to have a clear and logical understanding about most of the capital that we plant to invest?"

No. Many people believe it is not possible to outperform the market on a risk-adjusted basis. These people think the best way to make money is to be broadly invested.

I hope this helps?

Personally, I fall in between. I invest in ETFs and various funds within my 401k, but also have a sizable portfolio of individual holdings in my taxable account.
« Last Edit: May 25, 2014, 06:33:19 PM by rmendpara »

kyleaaa

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Re: paradox of balance
« Reply #13 on: May 25, 2014, 07:31:47 PM »
First off, index investing isn't based on the efficient market hypothesis at all. It's based on empirical experience and the arithmetic of active management. Index investing would work well even in a world of moderately inefficient markets where mispricings do occur.

Second, rebalancing has nothing to do with market timing or buying an asset class one perceives to be undervalued. Instead, it has to do with maintaining constant exposure to various risk factors. Again, the efficiency of markets has nothing to do with it.
« Last Edit: May 25, 2014, 07:34:52 PM by kyleaaa »

Mr Mark

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Re: paradox of balance
« Reply #14 on: May 25, 2014, 10:01:31 PM »
First off, index investing isn't based on the efficient market hypothesis at all. It's based on empirical experience and the arithmetic of active management. Index investing would work well even in a world of moderately inefficient markets where mispricings do occur.

Second, rebalancing has nothing to do with market timing or buying an asset class one perceives to be undervalued. Instead, it has to do with maintaining constant exposure to various risk factors. Again, the efficiency of markets has nothing to do with it.

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