Rebalancing in a Bear Market

The stock market crash in 2008 provides a good case study for rebalancing. If you are not familiar, rebalancing means selling some assets to buy other assets and putting your asset allocation back to what you originally wanted. Rebalancing is good for maintaining a portfolio because you are buying low and selling high.

For 2008, rebalancing means buying stocks and selling bonds. At the onset of the bear market in July 2008, I put together a plan for overbalancing, which buys more stocks than what regular rebalancing would do. "If rebalancing is good, overbalancing must be better." I reasoned.

My plan laid out in the previous post Embrace the Bear Market with Overbalancing was:

  1. After the stock market drops by 20% from its high, increase allocation to stocks by 5%. For each additional drop of 10 percentage points, increase stocks by another 5%.
  2. After the stock market drops by 40% from its high, increase allocation to stocks by 5% for each additional drop of 5 percentage points until I reach 85% stocks, 15% bonds.
  3. Take back the increased allocation to stocks if the stock market goes up by 10 percentage points from the point when the allocation was increased.

It’s a crude form of "be greedy when others are fearful." Is it market timing? Yes, no doubt about it. "Be fearful when others are greedy, and be greedy when others are fearful" is market timing.

Now that the market has recovered somewhat, it’s time to review the results. Did it work?

While I’d love to gloat about how I was able buy more and more shares as the stock market went lower and lower, I must say it didn’t work, at least not yet.

What went wrong? I did carry out the plan. I didn’t blink. 100% of my new cash in the last 12 months went into stocks. I did pick up some shares at very low prices. My entry into commodities was almost perfect. That fund is up 43% since I bought it in early December 2008. I tweeted about buying a chunk of S&P 500 fund on March 5, 2009, 2 trading days before S&P 500 hit the lowest point. It’s up 46% now.

However, because the crash went very deep and because S&P 500 is still 35% below its all time high, some of my earlier overbalancing purchases are still under water. Those losses offset the gains from the later purchases.

What if I didn’t do anything and what if I just did regular rebalancing? With multiple funds and new cash going into the portfolio at different times, it’s too complicated to reconstruct alternative realities. Instead, I tested this hypothetical scenario:

Suppose an investor had $10,000 on Jan. 2, 2008: 60% in Vanguard Total Stock Market Index Fund and 40% in Vanguard Total Bond Market Index Fund. What would have happened if this investor followed different rebalancing strategies?

The results are summarized in the table below. All data are between January 2, 2008 and July 31, 2009. For this 1-1/2 years, I ignored the small dividend and interest distributions from the two funds.

I tested four strategies:

1. Do Nothing. The investor held the funds throughout the entire period with no rebalancing.

2. Rebalance After End of the Year. The investor took a look at the portfolio at the end of 2008 and rebalanced back to 60% in stocks, 40% in bonds on Jan. 2, 2009.

3. Rebalance with a 5% Trigger. The investor rebalanced the portfolio back to 60% stocks 40% bonds whenever the actual composition of stocks went below 55% or above 65%.

4. Overbalance. My overbalancing plan.

In terms of the ending value on July 31, all four strategies produced similar results. The values are within 1.5% of each other. I wouldn’t say one strategy is better than another. Not rebalancing when rebalancing is supposed to help the most turned out to be not a big deal. That’s a surprise to me. Instead of being down 18% without rebalancing, you are down 17.4% or 16.8% with rebalancing, or down 17.5% with overbalancing. So?

In terms of the lowest point the portfolio reached, there is a big difference. Overbalancing is the worst. As the market went toward the March low, the overbalancing portfolio had more in stocks than the other portfolios. At the lowest point, it lost 41% since Jan. 2, 2008. The Do Nothing portfolio fared the best because it had the least in stocks at the March low. It lost "only" 33%. It takes a much stronger stomach to do overbalancing.

There is also a big difference in the current portfolio composition. Overbalancing had the most in stocks on July 31: 80%. The two rebalancing portfolios had 62% and 64% in stocks, respectively. The Do Nothing portfolio had 51% in stocks. If the stock market continues to recover, overbalancing will start to pay off.

At this time, overbalancing has taken on more downside without compensation on the upside (yet). The downward momentum of the stock market crash hurt it the most. It was too early in buying stocks. The two rebalancing strategies didn’t do much to the bottom line either. If the so called "rebalancing bonus" is real, not just due to randomness in the data, it is very small. It also comes at a cost of a larger downside.

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Comments

  1. says

    It is great to hear someone talk about an investment plan that does not work out as it is supposed. Because every other investment article talk like they have a plan and strategy that should yield profit in the future.

    I have also did some investment allocation maneuver during the past year. By having a larger cash allocation before the stock plunge I thought I will emerge as a winner when everyone else suffers. But looking at the balance in July it doesn’t seems I’m that much better than do nothing. I haven’t compare various scenarios in detail on a spreadsheet. It is just q quick impression.

  2. says

    TFB – I wonder, would you consider just changing your purchase allocation rates, instead of rebalancing your entire portfolio? (honest question, I’m wondering if others consider this)

    What I’m considering is instead of doing an annual, or semi-annual rebalancing of my portfolio, I will instead make regular changes to the allocation of for my scheduled share purchases (occurring with each employer paycheck).

    For instance, my current allocation for each purchase period is 100% stocks, but I will be moving away from that as the market goes up. So, maybe next month I will set it to 95% stocks, 5% bonds- and on up as the market goes.

    So, eventually the amount of shares of stocks vs bonds will change, though not as dramatically.

  3. Don says

    I’m not sold on the idea that it’s no big deal to save 1%. If you could do 1% better over 30 years, you might be 25% richer…. I suppose it’s fair to say that you won’t do 1% better every year.

    And this is probably much more important: You can’t forget of course what your assumptions were: a starting 60/40 portfolio. If you were not a rebalancer, you could hardly expect to start 2008 with that kind of portfolio. You’d very likely have had a higher allocation to stocks, and your losses would have been worse.

    So the conclusion could very well have been, “If you are a rebalancer, but end up in the hospital for a (short) period and suspend your allocation strategy for a time it probably won’t make a huge difference.”

  4. says

    @Dave – Changing the allocation on new cash is the same as rebalancing, only on a smaller scale. Think of putting 100% of new cash into stocks as a two-step process: first allocate new cash proportionally as the current portfolio composition, then sell some bonds to buy stocks. If changing the allocation dramatically as in overbalancing didn’t make much difference, small changes on the edge would do much less.

    @Don – 2008 was a record year. There was a huge divergence between stocks and bonds. Stocks were down 37%. Bonds were up 5%. For rebalancing, it can’t get any better than this. Prior to doing the math exercise, I was expecting a large difference, but the best I got was 1.2% from end-of-year rebalancing. Luck was a factor in end-of-year rebalancing. It just so happened the end of year was close to a market low. If the year ran from July to July, rebalancing would’ve been done in July 2008 and July 2009, missing the lows. I’m sure in a normal year the difference will be much less than 1%.

  5. pop77 says

    TFB,
    In a related note, one thing I am considering is to sell some actively managed funds and replacing them with ETF when I do asset allocation/rebalancing. Though this is a tax type question on wash sales will selling actively managed fund and buying index fund trigger wash sale rule?

  6. says

    @pop77 – Wash sale involves shares of “substantially identical securities.” I don’t think the ETF and actively managed funds are substantially identical. Different managers, different strategies. However the IRS has never clarified what exactly are substantially identical. See Substantially Identical Securities on Fairmark.

  7. says

    Great, honest post — and a nice new blog to me. In terms of your findings though, I have to agree with Don that 1% is very significant. If I could get an extra 1% a year from executing a couple of trades a month (after costs – crucially) why wouldn’t I — it’ll really add up? The rebalanced portfolio will probably be less volatile, too.

    That said this data is almost certainly skewed by your particular methods and start and end dates, as I’m sure you realise, so it can’t be considered definitive.

    Good deep investigation though! :)

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