Speculation, Rebalancing And Overbalancing

Asset allocation tends to be a rather staid option among investing strategies. Determine an allocation plan, contribute and rebalance regularly, and the job is pretty much finished. Achieving wealth slowly isn’t exactly sexy or exciting. The more intrepid allocators out there may venture into factor tilting or life cycle considerations.

At the opposite end of the spectrum is the overconfident trader that believes he can time the market. He shows a strong indifference towards the price he pays for any given asset and cares only that some one else will purchase said asset at a later date and at an even higher price–what Burton Malkiel refers to as the “greater fool” theory. [1a]

However, the “greater fool” theory requires some context. The dot-com bubble of the late 1990s provides one such example of the theory at work. Speculators who purchased stock at high prices with the intention of selling at an even higher price were no doubt disappointed to see prices decline (substantially) when the bubble eventually burst. Call this cohort the short-term greater fools. However, as Jeremy Siegel has demonstrated there has never been a 30 year period where the broader US stock market has failed to deliver a positive real rate of return. [2] Thus the greater fool theory really applies to short-term periods of speculation while the long-term fool doesn’t really look like much of a fool at all.

What we gather from this is that during short holding periods valuations matter and they matter a great deal. Markets are not always priced appropriately as history has shown: tulip bulbs in the 1630s, US stocks in the 1920s, Japanese stocks in the 1980s, and US housing prices in the 2000s. All of these “bubbles” eventually went bust and prices dropped back to a level that was thought to reflect the true underlying value of the respective assets. As Malkiel put it

The lesson, however, is not that markets occasionally can be irrational and that we should therefore abandon the firm-foundation theory of the pricing of financial assets. Rather, the clear conclusion is that, in every case, the market did correct itself. The market eventually corrects any irrationality–albeit in its own slow, inexorable fashion. [1b]

Eventually asset prices do correct or mean revert, sometimes slowly, and sometimes violently. Buying and selling assets–stocks, bonds, commodities or the asset class du jour–for short holding periods can be a slippery slope. The major problem that speculators run into very quickly is that of timing. Determining when or if a given asset will rise or fall has been the domain of pundits for centuries with varying degrees of success. [3]

The rational solution to this problem is simply not to play the game. The vast majority of individual investors are better served through a diversified portfolio of uncorrelated assets that is rebalanced regularly (selling assets that have appreciated and purchasing those that have performed poorly).

Rebalancing takes advantage of the returns that the market generates, it enforces a buy-low-sell-high strategy, and more importantly helps to control portfolio volatility. Consider the difference between a rebalanced and non-rebalanced portfolio

Starting Allocation
(Stocks / Bonds)
(Std Dev)
Ending Allocation
(Stocks / Bonds)
US Large Co. Stocks 100% / 0% 10.12% 20.07% 100% / 0%
Intermediate Treasuries 0% / 100% 5.25% 5.66% 0% / 100%
60/40 Rebalanced 60% / 40% 8.70% 12.18% 60% / 40%
60/40 Non-Rebalanced 60% / 40% 9.50% 16.56% 99% / 1%

Granted, this study takes place over an 89 year period, therefore the 99% / 1% ending allocation may be a little extreme. The basic idea here is that without rebalancing the overall portfolio will become more volatile as the asset(s) with higher returns and higher volatility take over the portfolio.

There’s additional evidence, under certain circumstances, that rebalancing can actually boost portfolio returns. In The Investor’s Manifesto William Bernstein demonstrated that an annually rebalanced 50/50 portfolio of US Large Co. Stocks and REITs provided an annualized return greater than either of two underlying assets on their own between 1995 and 2003. [4] This can certainly occur, but real world results tend to be less obvious and require that the underlying assets have certain characteristics

I will admit that I cherry-picked these two asset classes as well as this particular time period, in which the two asset classes often moved in radically different directions yet had nearly the same overall return, to more clearly demonstrate the benefits of diversification. Normally, diversification and rebalancing produce somewhat more subtle benefits, both in terms of risk reduction and return enhancement.

Investors can actually lose return with rebalancing, as would have occurred in the 1990s with Japanese and US stocks, when the former went nearly straight down, and the latter went nearly straight up. In that case, the investor would have been continually selling what was the best future performer and buying the worst future performer. [4]

The case of Japanese stocks provides the basis for an interesting thought experiment. While buying into a declining market may be an uncomfortable action, the concept of overbalancing–the buying and selling of assets beyond what is called for in an asset allocation strategy–can be downright scary, and seldom comes up as point of discussion. The mere mention of breaking a fixed allocation policy may be cause for banishment from some forums. Is a dogmatic fixed strategy the best path forward? Can overbalancing provide any benefit?

A simple 60/40 portfolio of US Large Company stocks and Treasury Notes provides a reasonable base line to test this hypothesis (the correlation between these two assets comes in at -0.03). Such a portfolio when rebalanced annually compounded at a rate of 8.70% from 1926 through 2014. Suppose that when stocks had a year with a negative return I temporarily adopted a 70/30 policy for the following year. In doing this I purchased additional shares of stock at a lower price and set my portfolio up for increased future returns when stocks turn positive. In theory this sounds great, but over the 89 year period the annualized return increased to only 8.76%.

Where this strategy really shines is when the negative return on stocks lasts for only one year. Several of these instances are captured in the chart below. For the overbalanced portfolio the policy allocation was 60/40, but after stocks produced a negative return it switched to 70/30 for the following year. In these cases the overbalancing strategy worked as expected

Overbalancing With 1-Year Declines

However, when stocks sustain losses in back-to-back years the results can get ugly. Continually overbalancing into a declining market over several years–much like Japanese stocks in the ’90s–ends up being a disaster as the late 1920s and early 2000s demonstrate

Overbalancing With Multi-Year Declines

What this shows is that overbalancing magnifies the outcome–good or bad. Attaining stellar results would require that one knows the direction that the market will move over the next year. Attempting to predict where stocks are going in any given year places you in the company of financial pundits, and potentially on the road to fool-dom.

1. Malkiel, Burton. A Random Walk Down Wall Street. W. W. Norton & Company. New York, NY. 2011.
(a) pp. 34-35.
(b) pp. 105-106.
(c) pp. 369-370.
2. Siegel, Jeremy. Stocks for the Long Run. Fourth Edition. McGraw-Hill. New York, NY. 2008. pp. 24-25.
3. Johnston, Michael. A Visual History of Market Crash Predictions. http://fundreference.com/articles/2015/1000555/the-clowns-of-wall-street/
4. Bernstein, William. The Investor’s Manifesto. John Wiley & Sons, Inc. Hoboken, New Jersey. 2010. pp. 86-87

Ben Carlson recently wrote about the rebalancing bonus from US stocks and Emerging Market stocks: The Emerging Markets Rout Continues. Similar to Bernstein’s example with US stocks and REITs, Emerging Markets and US Stocks had similar returns, but a low correlation over the period studied.

What I’m Reading
The enlightened view on managing other people’s money (Barry Ritholtz)
Warren Buffett on Booms, Bubbles, and Busts (Morgan Housel)
The More Unique Your Portfolio, The Greater Its Potential (Patrick O’Shaughnessy)