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:
- 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%.
- 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.
- 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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