Author Topic: Why rebalance? or rather, why a fixed AA (not target funds question)?  (Read 5589 times)

Left

  • Handlebar Stache
  • *****
  • Posts: 1157
Sorry, I know this has been asked everywhere on the internet but I couldn't find anything that was satisfactory since most of what I found was on "how" to rebalance and not "why"

From my understanding, a 100% stock would return the most over enough time. Also an 80/20 would have "similar" results to a 100% but slightly less to smooth out the bumps. And it gets "smoother" as you increase the bond portion of portfolio. Lastly, you want enough stocks in portfolio for it to grow with inflation, hence not many advocate for a 100% bonds portfolio.

So why rebalance? If I'm comfortable with both a 100% stocks and a 60/40 portfolio, my portfolio is around 80/20 (with the 80% split another 60/40 for a tilt I wanted). But is there a reason I should rebalance? I mean I doubt my bonds portion will increase more than my stocks part but if it does, I get more fixed income which I can reinvest. The more likely scenario is that the stocks portion does well and drops my bonds below 20%, in which case why would I worry about it? Is it because I want to "time" the next market crash? So is rebalancing just trading "growth" for "fixed" income in the event that there's a crash in the next year/time period between rebalancing?

My "goal" is to have enough fixed income that I can go 100% stocks forward. I won't get to this point until I FI in 15-18 years though, but my goal is about $1500/month (today's dollars). After I reach this point, is there a reason I shouldn't just go all stocks for all future contributions? If I feared a market crash, I could make it $2500/month fixed income instead or something like this and reinvest what I don't use, but it still doesn't mean I need an AA that is fixed and constantly being rebalanced (yearly or otherwise).

The reason for AA that I could think of, is that if you have enough in fixed income, you can overlook the stock portion dropping in a crash since the living costs are still covered, but if it is covered, why bother rebalancing away from stocks? Is AA only to help smooth out the 4% swr? If so, do people invest 100% stocks after they hit their 4% goal for spending costs, IE: they need $40k/year so they invest in an AA for the first $1 million, but then after that, why keep the same AA?
« Last Edit: January 17, 2015, 08:30:20 AM by eyem »

Dodge

  • Pencil Stache
  • ****
  • Posts: 790
Re: Why rebalance? or rather, why a fixed AA (not target funds question)?
« Reply #1 on: January 17, 2015, 08:39:01 AM »
The simple answer is, you rebalance to keep the same amount of risk. If you decided 60/40 was the amount of risk you wanted, and socks explode so you are now at 90/10, your portfolio is much more risky (when measured in terms of volatility) than you intended it to be. Rebalancing fixes that.

Yankuba

  • Handlebar Stache
  • *****
  • Posts: 1358
  • Location: Long Island, NY
Re: Why rebalance? or rather, why a fixed AA (not target funds question)?
« Reply #2 on: January 17, 2015, 08:39:56 AM »
Historically, small cap stocks have outperformed large cap stocks and value stocks have outperformed growth stocks, so I like to tilt my portfolio towards small and value. You can't do that with the target retirement funds. Additionally, the target retirement funds generally have a bit too much international exposure for my liking. But otherwise I think the target funds are cool.

Left

  • Handlebar Stache
  • *****
  • Posts: 1157
Re: Why rebalance? or rather, why a fixed AA (not target funds question)?
« Reply #3 on: January 17, 2015, 08:42:32 AM »
The simple answer is, you rebalance to keep the same amount of risk. If you decided 60/40 was the amount of risk you wanted, and socks explode so you are now at 90/10, your portfolio is much more risky (when measured in terms of volatility) than you intended it to be. Rebalancing fixes that.
this is similar to what I've been finding online, something like this http://news.morningstar.com/classroom2/course.asp?docId=3172&page=2&CN=COM

But my question is if my original "living" costs are covered, is there a reason I shouldn't just go 100% stocks going forward? So if having $X amount at 60/40 generates what I need to live on, then if I get more money to invest from job/etc should I not just invest this part into 100% stocks? Which would throw off the AA but if what I have already covers living, why bother trying to keep the same AA?

I keep seeing things say "you set up your original allocation to match your needs and your risk tolerance" but if I have enough fixed income, my needs are taken care of, and my risk tolarence is high because my needs are covered. So at this point, is there a reason to keep an AA?
« Last Edit: January 17, 2015, 08:44:31 AM by eyem »

Heckler

  • Handlebar Stache
  • *****
  • Posts: 1346
Re: Why rebalance? or rather, why a fixed AA (not target funds question)?
« Reply #4 on: January 17, 2015, 08:43:56 AM »
Don't forget, stock will also loose value.

https://www.bogleheads.org/wiki/Rebalancing

The objective is to maintain a consistent mix of asset classes (most commonly equities vs. fixed income) in order to control risk at the level desired by the investor.


http://canadiancouchpotato.com/2011/02/22/why-rebalance-your-portfolio/

The problem is that asset allocations don’t stay constant. As the markets move month by month, your portfolio’s stock-bond mix will change, sometimes dramatically. If you had a 60-40 portfolio in mid-2008, the stock portion fell to about 45% by March 2009. If you were at 60-40 when the market bottomed, then your mix would be close to 80% equities today.




GGNoob

  • Pencil Stache
  • ****
  • Posts: 725
  • Age: 33
  • Location: Colorado
Re: Why rebalance? or rather, why a fixed AA (not target funds question)?
« Reply #5 on: January 17, 2015, 08:44:19 AM »
The simple answer is, you rebalance to keep the same amount of risk. If you decided 60/40 was the amount of risk you wanted, and socks explode so you are now at 90/10, your portfolio is much more risky (when measured in terms of volatility) than you intended it to be. Rebalancing fixes that.

Along with keeping the same amount of risk, you also get to sell high (sell what's doing good) and buy low (buy whats doing bad). Doing so may actually increase your returns.

Heckler

  • Handlebar Stache
  • *****
  • Posts: 1346
Re: Why rebalance? or rather, why a fixed AA (not target funds question)?
« Reply #6 on: January 17, 2015, 08:45:49 AM »

But my question is if my original "living" costs are covered, is there a reason I shouldn't just go 100% stocks going forward? So if having $X amount at 60/40 generates what I need to live on, then if I get more money to invest from job/etc should I not just invest this part into 100% stocks? Which would throw off the AA but if what I have already covers living, why bother trying to keep the same AA?

I keep seeing things say "you set up your original allocation to match your needs and your risk tolerance" but if I have enough fixed income, my needs are taken care of, and my risk tolarence is high because my needs are covered. So at this point, is there a reason to keep an AA?

Because you're living expenses won't be covered after the next market crash.

Heckler

  • Handlebar Stache
  • *****
  • Posts: 1346
Re: Why rebalance? or rather, why a fixed AA (not target funds question)?
« Reply #7 on: January 17, 2015, 08:47:50 AM »
Oh, hang on.  Are you saying you have enough bonds that provide enough dividends per year for your living costs?   In that case, I'm in over my head here.

Dodge

  • Pencil Stache
  • ****
  • Posts: 790
Re: Why rebalance? or rather, why a fixed AA (not target funds question)?
« Reply #8 on: January 17, 2015, 08:48:29 AM »

The simple answer is, you rebalance to keep the same amount of risk. If you decided 60/40 was the amount of risk you wanted, and socks explode so you are now at 90/10, your portfolio is much more risky (when measured in terms of volatility) than you intended it to be. Rebalancing fixes that.
this is similar to what I've been finding online, something like this http://news.morningstar.com/classroom2/course.asp?docId=3172&page=2&CN=COM

But my question is if my original "living" costs are covered, is there a reason I shouldn't just go 100% stocks going forward? So if having $X amount at 60/40 generates what I need to live on, then if I get more money to invest from job/etc should I not just invest this part into 100% stocks? Which would throw off the AA but if what I have already covers living, why bother trying to keep the same AA?

That's a personal decision. I wouldn't do it, because I can't predict what the next crash/period of high inflation/Black Swan will look like, so it doesn't make sense (to me) to put all my eggs in one basket.

In other words, take on as much risk as you need to, but no more. I don't feel the risk outweighs the benefits.

That being said, if you're comfortable with the risk, I think it's a good plan.

Left

  • Handlebar Stache
  • *****
  • Posts: 1157
Re: Why rebalance? or rather, why a fixed AA (not target funds question)?
« Reply #9 on: January 17, 2015, 08:48:47 AM »
The simple answer is, you rebalance to keep the same amount of risk. If you decided 60/40 was the amount of risk you wanted, and socks explode so you are now at 90/10, your portfolio is much more risky (when measured in terms of volatility) than you intended it to be. Rebalancing fixes that.

Along with keeping the same amount of risk, you also get to sell high (sell what's doing good) and buy low (buy whats doing bad). Doing so may actually increase your returns.
I think this was what was missing? But isn't this more of a "tilting" of the portfolio? You are tilting it towards what is "cheaper". My understanding of AA is that it is equity/fixed income. Anything else in it is a tilt of portfolio? Either tilting towards small cap/etc?


Quote
Oh, hang on.  Are you saying you have enough bonds that provide enough dividends per yer for your living costs?   In that case, I'm in over my head here.
Basically yes, fixed either through bonds/rentals/job/etc. Something I can get dependably and know how much I'll be getting.

Indexer

  • Handlebar Stache
  • *****
  • Posts: 1437
Re: Why rebalance?
« Reply #10 on: January 17, 2015, 08:53:15 AM »
Well rebalancing isn't just stocks VS bonds.

How about domestic VS international, large VS small cap... etc.

If you build the perfect portfolio for you why would you never go in and adjust back to that portfolio?  I'm currently about 65% US stocks, 35% international stocks.  So I'm 100% stock, but I still rebalance.  When you rebalance you are also buying what is cheap at the time.  Rebalancing also forces you to buy what is out of favor so you buy the thing that is cheaper.  Studies have shown it bumps up your long term returns because of this.

For most people its also about risk tolerance.  A 60S/40B given time could turn into a 80/20 and in a crisis the first goes down 25, the second goes down 35.  Losing over a third will freak out some people more than losing a fourth.  If you are ok with fluctuations then that part doesn't matter as much.

Now another way of looking at it that might interest you based on what you have said is more of a time based allocation.  Throw in your own numbers & allocations.  This is just an example.
Money you won't need for over 10 years = 100% stock.
Money you will need in the next 5-10 years = 60/40
Money you will need in 5 years = 20/80
Money you will need in the next 3-6 months= cash.

If there is a crash it will hit your long term money more than your short term so you have time to recover, and as a result you delay taking money from the 10yr account and keep using the money in the shorter term accounts while it recovers(in a way rebalancing...).  You could have separate accounts/funds for the 5 yr, 5-10, and 10+ or you could just use a small excel spreadsheet to calculate it and rebalance the whole portfolio as one thing.  If your FI then the long term should be growing fast enough to replenish the shorter term accounts and THEN some.  Now that is looking at taking the money out.  Obviously as you are putting money in if you are 10+yrs from retirement its 100% stock, and once you are within 10 years you start adding bonds.  Again use your own numbers.

I don't do this with my investments, but I do it with my HSA.  Money I might need to cover the deductible on my health insurance= cash, annual maximum out of pocket = 20S/80B, and the rest is stocks.

Dodge

  • Pencil Stache
  • ****
  • Posts: 790
Re: Why rebalance? or rather, why a fixed AA (not target funds question)?
« Reply #11 on: January 17, 2015, 08:53:53 AM »

The simple answer is, you rebalance to keep the same amount of risk. If you decided 60/40 was the amount of risk you wanted, and socks explode so you are now at 90/10, your portfolio is much more risky (when measured in terms of volatility) than you intended it to be. Rebalancing fixes that.

Along with keeping the same amount of risk, you also get to sell high (sell what's doing good) and buy low (buy whats doing bad). Doing so may actually increase your returns.

Yes, it may increase returns, but it may also reduce them. I leave that part out when talking about rebalancing so people don't start to do it in an effort to chase performance :-P

The main purpose of rebalancing is to control risk.

Dodge

  • Pencil Stache
  • ****
  • Posts: 790
Re: Why rebalance? or rather, why a fixed AA (not target funds question)?
« Reply #12 on: January 17, 2015, 08:56:12 AM »

The simple answer is, you rebalance to keep the same amount of risk. If you decided 60/40 was the amount of risk you wanted, and socks explode so you are now at 90/10, your portfolio is much more risky (when measured in terms of volatility) than you intended it to be. Rebalancing fixes that.

Along with keeping the same amount of risk, you also get to sell high (sell what's doing good) and buy low (buy whats doing bad). Doing so may actually increase your returns.
I think this was what was missing? But isn't this more of a "tilting" of the portfolio? You are tilting it towards what is "cheaper". My understanding of AA is that it is equity/fixed income. Anything else in it is a tilt of portfolio? Either tilting towards small cap/etc?


Quote
Oh, hang on.  Are you saying you have enough bonds that provide enough dividends per yer for your living costs?   In that case, I'm in over my head here.
Basically yes, fixed either through bonds/rentals/job/etc. Something I can get dependably and know how much I'll be getting.

Bonds/Rentals/Jobs might not be dependable during the next crash. It's dangerous to expect the same cash flow both when times are good, and when times are bad.

James

  • Handlebar Stache
  • *****
  • Posts: 1680
  • Age: 47
  • Location: Rice Lake, WI
Re: Why rebalance? or rather, why a fixed AA (not target funds question)?
« Reply #13 on: January 17, 2015, 08:57:06 AM »
There is a very specific reason for portfolio rebalancing. It is not to balance out the risk, though it does that also. The reason you rebalance is to "buy low and sell high".

Say you have 80k in stock and 20k in bonds. Stocks go up by 20% on year and bonds go up by 5%. At your rebalancing point you would have 96k stock and 21k bonds, so you would sell 2.4k of your stock fund and buy bonds. That would mean you sold high and bought low to some degree. Stocks may continue to go up, but you have locked in some of those increases by switching some funds to bonds.

Say instead stocks drop by 20% and bonds go up by 2%. At your rebalancing point you would have 64k in stock and 20.4k in bonds. Your total invested is now 84.4k so you would move about 4k in bonds into stocks. That would mean you bought low to some degree.

This is not "timing" the market in a traditional sense, because you are not at any point deciding the market is high or low. You are simply maintaining a balance that will automatically switch funds to the underweighted part of your portfolio.

This does promote a more stable climb, but over time the lower return of bonds balances the effects of the "buy low sell high" benefit, resulting in similar returns of the all stocks portfolio. In the end stability is the key result, while hoping to match the return of stocks in the long run.

Personally, while seeing the value of the above, I have chosen to go all stocks simply because I don't need the benefits of stability. I don't intend to take money out of the market for a very long time, and I don't want to rebalance funds. I also don't want to pay a company like betterment to do it for me. But I believe in the method itself, it does work and have real benefits.

Left

  • Handlebar Stache
  • *****
  • Posts: 1157
Re: Why rebalance? or rather, why a fixed AA (not target funds question)?
« Reply #14 on: January 17, 2015, 09:06:14 AM »
There is a very specific reason for portfolio rebalancing. It is not to balance out the risk, though it does that also. The reason you rebalance is to "buy low and sell high".

I think this is what confused me, to me rebalancing from how I've been reading it is just to negate "risk" by market timing a portfolio. So why would I want to do this if I have my living costs already covered? Since anything else is just timing the next market crash.

@Indexer, that is my plan. I have my taxable setup at 80(60/40 tilt) / 20 (yes I know it throws out dividends that I'm being taxed on, I don't mind it since I plan to retire before it plus my job gets taxed too much. IE as it gives more dividends, I can work less and less until I'm fully retired and I stay in same tax bracket. My roth is 100% stocks since I plan to use this one last so I want it to grow the most. My 401k is a target fund (not enough options for me so this is best choice) and my intermediate fund after my taxable and cash emergency funds but before my roth. When I do the roth pipeline, I plan to roll over X amount, and then use a portion of that to supplement what my taxable couldn't cover (or if I plan to travel) and then rest stays in roth at 100% stocks.

Quote
Bonds/Rentals/Jobs might not be dependable during the next crash. It's dangerous to expect the same cash flow both when times are good, and when times are bad.
So how does rebalancing fix this problem of a market crash? You can't balance yourself out of it.
« Last Edit: January 17, 2015, 09:13:15 AM by eyem »

James

  • Handlebar Stache
  • *****
  • Posts: 1680
  • Age: 47
  • Location: Rice Lake, WI
Re: Why rebalance? or rather, why a fixed AA (not target funds question)?
« Reply #15 on: January 17, 2015, 09:28:34 AM »
Balancing doesn't fix the problem of a market crash, it simply helps you benefit from the market crash by having you purchase whatever is low with funds from whatever is not as low. But you are correct, you can't balance yourself out of it, the majority of funds are in stocks and are going to crash no matter what, you cannot negate risk and have high growth, or everyone would choose that option and we wouldn't be having this discussion... :)


If you are not going to rebalance your portfolio then the bonds will just drag down overall returns over time. In that case if you can tolerate the risk and volatility then I would go all stock portfolio. There is not a universal "why" for everyone in choosing a strategy, once you know all the facts then the only one to determine the "why" for your selection of a strategy is you.

Dodge

  • Pencil Stache
  • ****
  • Posts: 790
Re: Why rebalance? or rather, why a fixed AA (not target funds question)?
« Reply #16 on: January 17, 2015, 09:30:46 AM »
Quote
Bonds/Rentals/Jobs might not be dependable during the next crash. It's dangerous to expect the same cash flow both when times are good, and when times are bad.
So how does rebalancing fix this problem of a market crash? You can't balance yourself out of it.

I wasn't referring to rebalancing in that quote, I was referring to your, "Basically yes, fixed either through bonds/rentals/job/etc. Something I can get dependably and know how much I'll be getting."

If you start going 100% stocks, because you have enough "dependable" fixed income when times are good (like when the market is at an all-time high), you might find yourself without enough "dependable" fixed income during the next crash.  It doesn't sound like a good idea to me, because it justifies not having a buffer in fixed income, based on an assumption that fixed income will not be affected by the next crash.

This is unknowable.

daymare

  • Bristles
  • ***
  • Posts: 464
  • Age: 30
Re: Why rebalance? or rather, why a fixed AA (not target funds question)?
« Reply #17 on: January 17, 2015, 11:00:29 AM »
Quote
Along with keeping the same amount of risk, you also get to sell high (sell what's doing good) and buy low (buy whats doing bad). Doing so may actually increase your returns.

This is basically it - rebalancing periodically (maybe once a year, nothing too crazy frequent) is a good way to stay disciplined (buy low, sell high), and not get carried away with current trends by buying more stocks when stocks are high (something we may be wont to do).

Tyler

  • Handlebar Stache
  • *****
  • Posts: 1162
Re: Why rebalance? or rather, why a fixed AA (not target funds question)?
« Reply #18 on: January 17, 2015, 12:41:32 PM »
This Forbes article explains the benefits of rebalancing pretty concisely. 

http://www.forbes.com/sites/greggfisher/2014/10/17/portfolio-rebalancing-theory-and-practice/

You can also look into the math of the rebalancing bonus as described by William Bernstein (in "The Intelligent Asset Allocator", I believe).  Sometimes rebalancing provides greater returns than buy & hold. 

skyrefuge

  • Handlebar Stache
  • *****
  • Posts: 1007
  • Location: Suburban Chicago, IL
Re: Why rebalance? or rather, why a fixed AA (not target funds question)?
« Reply #19 on: January 17, 2015, 01:02:05 PM »
My "goal" is to have enough fixed income that I can go 100% stocks forward. I won't get to this point until I FI in 15-18 years though, but my goal is about $1500/month (today's dollars). After I reach this point, is there a reason I shouldn't just go all stocks for all future contributions? If I feared a market crash, I could make it $2500/month fixed income instead or something like this and reinvest what I don't use, but it still doesn't mean I need an AA that is fixed and constantly being rebalanced (yearly or otherwise).

Maybe this is where the confusion comes from. For most people (at least on this forum), the theory is that their living expenses in retirement come from the total return on their entire portfolio, not just from the interest payments from their bonds. VBTLX (Vanguard's Total Bond Market fund) is currently yielding 2%. To generate $1500/month in interest from that, you would need $900K. If you have an 80% stock/20% bond AA, that means your 80% stock portfolio is worth $3.6M, for a total portfolio value of $4.5M. Your $1500/mo would be a mere 0.4% withdrawal rate from that portfolio (or, conversely, at a 4% withdrawal rate, you could spend $15,000/mo).

In other words, if you reach that point, you will have ridiculously over-saved. From that perspective, yes, an asset allocation is essentially irrelevant, since any asset allocation (even 100% cash) will provide sufficient income from the rest of your life.

For the rest of us, we intend to grow our portfolio only to the point where it's 25x (or maybe 33x) our expenses. Our retirement income will at least partially come from stock-price appreciation. Thus, we decide what risk-level we can emotionally tolerate (how much can we watch our portfolio value drop before going crazy and selling it all?), set our asset allocation based on that risk-tolerance, and then maintain it over time via rebalancing.

Letting the stock portion grow too large increases the risk that we will mentally fuck up and sell it all during a future market crash. Letting the bond portion grow too large increases the risk that we will spend extra years building our portfolio unnecessarily large. Both are risks we want to avoid, so we rebalance.

Left

  • Handlebar Stache
  • *****
  • Posts: 1157
Re: Why rebalance? or rather, why a fixed AA (not target funds question)?
« Reply #20 on: January 17, 2015, 04:47:45 PM »
@Skyrefuge, but at $1500/month and using the 4% total return, I would need $450k. Since I haven't seen the 4% be tied to a certain AA, I'm assuming 4% be for any AA from 100/0 to 0/100. So once I get my $450k invested, this would generate my $1500/month "fixed" because according to the 4% rule, I can reliably withdraw that much each month. So any money after that I would move to a 2nd account and invest at 100% stocks. I could rebalance the first account to keep my "swr" income "safe".

When I said "fixed" income, yes I did plan on using bonds but I also meant the 4% rule or even rentals. As long as I can get $1500/month, my living cost would be covered and anything above that amount I would invest in stocks which would alter my AA.

I guess my real question is why aren't people deciding their AA based on their spending instead of their risk tolerance? If I feel like 100/0 would drop 40% and hurt the amount of living money, I would add bonds so it drops less. I understand this to be the risk part of equation. As I add bonds, I reduce the amount my portfolio drops. But once I get a certain amount of money in the bonds side of the equation, it seems like I don't need more bonds. So once I hit this target amount, does AA become less important? Like Skyrefuge pointed out, at some point once you have enough invested, the actual AA isn't as important?

The forbes link http://www.forbes.com/sites/greggfisher/2014/10/17/portfolio-rebalancing-theory-and-practice/ actually is part of what causes my confusion. Because in my mind the article says that leaving the portfolio at 100% stocks (it's S&P 500) gave the highest annual return of 10%. So if I had enough invested in the 5-year treasury notes which returned 5%, I would in theory only need $360k of notes to cover my living. I plan to have $500k to be on safe side. So if $1.5m is my goal, would it not make sense for the $1m between $500k to $1.5m be 100% stocks? Yes this is an AA of 1/3 notes but if my portfolio grew to 2m, I would still only need $500k notes so my AA would change. In a market drop, my portfolio could fall completely to $500k where it is entirely notes, and I would still be fine until markets recovered. I'm saying notes to use the examples in link but I plan to use a 4% SWR as my "fixed" income where my dividends from investments/bonds don't cover.

I do see you guys' point about rebalancing as selling high and buying low. When the markets are doing well, stocks are up and you want to sell them and buy bonds which are low. And the opposite in a down market. But I guess I wasn't reading rebalancing as what this accomplished before. I read it and thought I understood it as people rebalanced to time the next market crash and their "risk" tolerance at how much the portfolio would drop. Not that it was to lock in the high returns and buy "discounted" bond/stock (depending on which is being bought).

I'm going to stick with my 80/20 AA since it did well for me in the past year. Well, being around 10%, which is lower than if I was 100% stocks but better than if I left it in bank. I haven't had to rebalance yet because I haven't been in market long enough. I'm just researching and planning things out for the eventual future where I'll have to make these decisions. I just always figured that AA was useful up until you have reached your "fixed" income goals then it could be 100% stocks on wards. That it wasn't something that I would be forever nit picking over. If I had enough to live on, does it really matter what the rest of my portfolio is doing?
« Last Edit: January 17, 2015, 05:04:29 PM by eyem »

RapmasterD

  • Pencil Stache
  • ****
  • Posts: 589
  • Location: SF Peninsula
Re: Why rebalance? or rather, why a fixed AA (not target funds question)?
« Reply #21 on: January 17, 2015, 05:02:00 PM »
The logic says you rebalance to buy low and sell high.

But maybe this equates to selling your winners.

Therefore, maybe within an investment class like stocks, rebalancing is overrated. Hmmmmmmm........

http://www.marketwatch.com/story/why-rebalancing-could-be-a-huge-mistake-2013-11-20?page=1


skyrefuge

  • Handlebar Stache
  • *****
  • Posts: 1007
  • Location: Suburban Chicago, IL
Re: Why rebalance? or rather, why a fixed AA (not target funds question)?
« Reply #22 on: January 17, 2015, 05:43:16 PM »
@Skyrefuge, but at $1500/month and using the 4% total return, I would need $450k. Since I haven't seen the 4% be tied to a certain AA, I'm assuming 4% be for any AA from 100/0 to 0/100.

Incorrect. Asset allocation is critical to the SWR. Using cFIREsim, it shows the following success rates for a 50-year period with the following stock/bond allocations:

100/0: 84%
75/25: 77%
50/50: 57%
0/100: 17%

So once I get my $450k invested, this would generate my $1500/month "fixed" because according to the 4% rule, I can reliably withdraw that much each month. So any money after that I would move to a 2nd account and invest at 100% stocks. I could rebalance the first account to keep my "swr" income "safe".

Yes, you could do that. No one here would do that though, because it's anti-mustachian. Once we have enough money invested to safely provide for our happiness, we stop working. So there is no "2nd account". We don't want to amass a big pile of money for no reason that we'll never use. If we did, sure, the AA could be anything, because, who cares?

I guess my real question is why aren't people deciding their AA based on their spending instead of their risk tolerance?

Because in the mustachian world, your required portfolio balance (at a particular AA) is determined by your spending. "I spend X, so I need 25X invested 80/20, and then I can retire". Your world seems to be the opposite, where for some reason your portfolio value is unrelated to your spending: "I have a portfolio of Z, but my expenses are covered by 0.25*Z, so the AA of 0.75*Z is irrelevant".

I would in theory only need $360k of notes to cover my living. I plan to have $500k to be on safe side. So if $1.5m is my goal, would it not make sense for the $1m between $500k to $1.5m be 100% stocks? Yes this is an AA of 1/3 notes but if my portfolio grew to 2m, I would still only need $500k notes so my AA would change.

Yeah, so I think our understanding is actually not too different. It seems you agree that maintaining an AA via rebalancing is important for the portion of your portfolio that safely covers your expenses. The only difference is that you have a goal to acquire 3X that amount, while most Mustachians will only acquire 1X.

If you have an excess supply like you describe, there are (at least) two competing schools of thought that are endlessly debated: go conservative (more bond-heavy) with your AA, because "if you've already won, why keep playing the game?"  Or, go risky (more stock-heavy) with your AA, because "who cares if you lose money you didn't need anyway?" Neither approach is definitively right or wrong, and the easiest way to avoid having to figure out which route to take for yourself is to avoid having that excess supply in the first place. :-)
« Last Edit: January 17, 2015, 05:44:56 PM by skyrefuge »

Dodge

  • Pencil Stache
  • ****
  • Posts: 790
Re: Why rebalance? or rather, why a fixed AA (not target funds question)?
« Reply #23 on: January 17, 2015, 05:44:08 PM »
@Skyrefuge, but at $1500/month and using the 4% total return, I would need $450k. Since I haven't seen the 4% be tied to a certain AA, I'm assuming 4% be for any AA from 100/0 to 0/100. So once I get my $450k invested, this would generate my $1500/month "fixed" because according to the 4% rule, I can reliably withdraw that much each month. So any money after that I would move to a 2nd account and invest at 100% stocks. I could rebalance the first account to keep my "swr" income "safe".

When I said "fixed" income, yes I did plan on using bonds but I also meant the 4% rule or even rentals. As long as I can get $1500/month, my living cost would be covered and anything above that amount I would invest in stocks which would alter my AA.

I guess my real question is why aren't people deciding their AA based on their spending instead of their risk tolerance? If I feel like 100/0 would drop 40% and hurt the amount of living money, I would add bonds so it drops less. I understand this to be the risk part of equation. As I add bonds, I reduce the amount my portfolio drops. But once I get a certain amount of money in the bonds side of the equation, it seems like I don't need more bonds. So once I hit this target amount, does AA become less important? Like Skyrefuge pointed out, at some point once you have enough invested, the actual AA isn't as important?

The forbes link http://www.forbes.com/sites/greggfisher/2014/10/17/portfolio-rebalancing-theory-and-practice/ actually is part of what causes my confusion. Because in my mind the article says that leaving the portfolio at 100% stocks (it's S&P 500) gave the highest annual return of 10%. So if I had enough invested in the 5-year treasury notes which returned 5%, I would in theory only need $360k of notes to cover my living. I plan to have $500k to be on safe side. So if $1.5m is my goal, would it not make sense for the $1m between $500k to $1.5m be 100% stocks? Yes this is an AA of 1/3 notes but if my portfolio grew to 2m, I would still only need $500k notes so my AA would change. In a market drop, my portfolio could fall completely to $500k where it is entirely notes, and I would still be fine until markets recovered. I'm saying notes to use the examples in link but I plan to use a 4% SWR as my "fixed" income where my dividends from investments/bonds don't cover.

I do see you guys' point about rebalancing as selling high and buying low. When the markets are doing well, stocks are up and you want to sell them and buy bonds which are low. And the opposite in a down market. But I guess I wasn't reading rebalancing as what this accomplished before. I read it and thought I understood it as people rebalanced to time the next market crash and their "risk" tolerance at how much the portfolio would drop. Not that it was to lock in the high returns and buy "discounted" bond/stock (depending on which is being bought).

I'm going to stick with my 80/20 AA since it did well for me in the past year. Well, being around 10%, which is lower than if I was 100% stocks but better than if I left it in bank. I haven't had to rebalance yet because I haven't been in market long enough. I'm just researching and planning things out for the eventual future where I'll have to make these decisions. I just always figured that AA was useful up until you have reached your "fixed" income goals then it could be 100% stocks on wards. That it wasn't something that I would be forever nit picking over. If I had enough to live on, does it really matter what the rest of my portfolio is doing?

The 4% rule is very much dependent on your AA.  Go to CFiresim.com, put in some variables, and on the right select:

Monte Carlo
and
Success rates with various allocations

Then run the simulation.  If you want to know more about Monte Carlo simulations, click "What is Monte Carlo" in the link below:

https://retirementplans.vanguard.com/VGApp/pe/pubeducation/calculators/RetirementNestEggCalc.jsf

You'll see some results which are really bad for 100% equities:



But most of them look something like this:



You'll see the success rate varies fairly significantly, based on the asset allocation.  I'd caution against going 100% bonds/treasury notes until you reach the 4% rule, then putting all future contributions towards 100% stocks.  You're overthinking it.  I recommend sticking with your 80/20 for the duration.  That's a good allocation for both the accumulation and retirement phases, which keeps things really simple :)

Left

  • Handlebar Stache
  • *****
  • Posts: 1157
Re: Why rebalance? or rather, why a fixed AA (not target funds question)?
« Reply #24 on: January 17, 2015, 08:06:07 PM »
Yes, you could do that. No one here would do that though, because it's anti-mustachian. Once we have enough money invested to safely provide for our happiness, we stop working. So there is no "2nd account". We don't want to amass a big pile of money for no reason that we'll never use. If we did, sure, the AA could be anything, because, who cares?
...
Yeah, so I think our understanding is actually not too different. It seems you agree that maintaining an AA via rebalancing is important for the portion of your portfolio that safely covers your expenses. The only difference is that you have a goal to acquire 3X that amount, while most Mustachians will only acquire 1X.
ah, I think I missed this part of the MMM community :S I always figured that even on MMM, people would still receive more income than they are spending, even by $1, so I wondered what they did with the excess. I mean MMM had an article about getting richer after FI (I lost the link), so I figured this would fit in with it. If I got richer post FI, what do I invest in once my FI money is obtained?

And yes, I think I am going to stock pile 2x to 3x what I need before I RE, but I never planned to RE once I hit FI either. hence, I planned to work until 45 instead of 35. And I quite like my job currently. I see no reason why this would change, or at least no reason that I couldn't find another job that I'd like in the future if I did want to switch careers. Even being a FIRE landlord is a form of a job.

edit: found the article http://www.mrmoneymustache.com/2012/05/14/first-retire-then-get-rich/
« Last Edit: January 17, 2015, 08:15:25 PM by eyem »

steveo

  • Handlebar Stache
  • *****
  • Posts: 1943
Re: Why rebalance? or rather, why a fixed AA (not target funds question)?
« Reply #25 on: January 18, 2015, 01:54:51 AM »
The simple answer is, you rebalance to keep the same amount of risk. If you decided 60/40 was the amount of risk you wanted, and socks explode so you are now at 90/10, your portfolio is much more risky (when measured in terms of volatility) than you intended it to be. Rebalancing fixes that.

Along with keeping the same amount of risk, you also get to sell high (sell what's doing good) and buy low (buy whats doing bad). Doing so may actually increase your returns.

This is what I like about using some form of asset allocation. My take is buy the riskier assets first depending on where the market is at historically and then diversify over time but maintain some of AA in order to help you with buying low and selling high.

skyrefuge

  • Handlebar Stache
  • *****
  • Posts: 1007
  • Location: Suburban Chicago, IL
Re: Why rebalance? or rather, why a fixed AA (not target funds question)?
« Reply #26 on: January 18, 2015, 09:44:28 AM »
ah, I think I missed this part of the MMM community :S I always figured that even on MMM, people would still receive more income than they are spending, even by $1, so I wondered what they did with the excess.

The safety of a withdrawal rate will never be anything more than an educated guess. The only time you'll know whether you received an "excess" is when you die and still have money in your bank account. On a year-to-year basis, it's impossible to know if you've had an excess. Maybe your portfolio rises 20% in value, but that doesn't mean you have a 20%-4%=16% excess, because some or all of that 16% will be necessary to provide your 4% withdrawal in a future year when your portfolio drops 20%.

But sure, as your actual withdrawal rate drops well below 4% (maybe <2.5% for a 5 or 10 year period), your confidence that you truly have a year-to-year excess can grow. And then you have the freedom to adjust your AA to take on either more risk or less risk. (you seem to be thinking in terms of two pots of money, each with a different AA: 80/20 for your "safe" pot and 100/0 for your "excess" pot. I guess that's one way of thinking about it, but it's mathematically no different than having a single pot where you've tilted the allocation to 90/10 or whatever.)

I mean MMM had an article about getting richer after FI (I lost the link), so I figured this would fit in with it.

That's actually one of the few MMM articles I left a comment on. He had two reasons why we'd continue to get richer, and I objected to the first one: our expenses in retirement would be lower than expected. They were lower for him, because he didn't have MMM around to tell him how his expenses would be lower in retirement. But for those of us who have now read MMM, we're already factoring in those lowered expenses (or have already achieved them pre-retirement).

For the second reason, that we would find people wanting to give us money for things we just want to do anyway, I'd say that remains to be seen. MMM seems to think making money in retirement is almost impossible to avoid, but I'm not sure how much of that is personal bias from his own personality/skills/experience. I think we need a larger sample of FIREd Mustachians to truly know how common it is. We can definitely say that MMM is an extreme outlier in the amount of income he's generating post-FIRE.