r2i forum

Just out of curiosity, I ran some calculations assuming a portfolio consisting of 2 asset classes (A and B) with perfect negative correlation of returns (i.e. when A goes up 25%, B goes down 25%). Here are the results I got - one with no rebalancing between the 2 asset classes and the other with rebalancing. To have some fun, I threw in some randomness in the years in which the returns of the asset classes went up or down while maintaining perfect -ve correlation between them each year.

I could not believe my eyes. Assuming a 30% return up and down in each year, the portfolio with no rebalancing actually lost value as opposed to the portfolio with rebalancing.

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0.30 No rebalancing With rebalancing
Year A B Total A B Total
1.0000 1.0000 2.0000 1.0000 1.0000 2.0000
Y1 0.7000 1.3000 2.0000 0.7000 1.3000 2.0000
Y2 0.9100 0.9100 1.8200 1.3000 0.7000 2.0000
Y3 0.6370 1.1830 1.8200 0.7000 1.3000 2.0000
Y4 0.8281 0.8281 1.6562 1.3000 0.7000 2.0000
Y5 1.0765 0.5797 1.6562 1.3000 0.7000 2.0000
Y6 0.7536 0.7536 1.5071 0.7000 1.3000 2.0000
Y7 0.9796 0.5275 1.5071 1.3000 0.7000 2.0000
Y8 1.2735 0.3692 1.6428 1.3000 0.7000 2.0000
Y9 0.8915 0.4800 1.3715 0.7000 1.3000 2.0000
Y10 0.6240 0.6240 1.2481 0.7000 1.3000 2.0000
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Am I doing this right ? Can rebalancing actually affect the outcome of your portfolio so much ?

Regards
vishwa

Rebalancing affects the outcome of the portfolio quite a bit. In essence it is a mechanism of value averaging.

If over long term, investments are to yield x%, then rebalancing shifts more money at opportune times in an investment, i.e when the investment is down, thus yielding a higher return for the shifted money. In essence the proces catches the valleys.

BTW, two investments perfectly negatively correlated do not form good investment. I guess 200 shares long IBM and 200 shares short IBM would be example of two investments perfectly negatively corelated.

The corelations over short duration is what matters, so that it gives a lower volatility and yet still a return long term.

Desi,

If one is rebalancing every year, is it a good idea to reinvest dividends?

Thanks,

Laks,

Yes, in my opinion. Keeping dividends (long term money) in the lowest yielding instruments (money market) is not a good thing. This process will repeat every year and the net impact might turn out to be that 2 to 5% of your money would always be sitting in cash and the AAP will have only 9X% in bonds and equities.

Desi,

Would this hold true for someone who is retiring ? I can see someone who is still in the earning phase retaining the capacity to rebalance with newly investable funds. But, for someone who is no longer drawing a salary, would'nt it be better if the dividends and capital gains are not reinvested and instead used for rebalancing ?

Thanx
vishwa

Yup, rebalancing is a pretty effective method if you could find low correlation assets.

However, try telling this to a Japanese investor! Think of how a Japanese investor feels after rebalancing into Japanese stocks year after year as they went down and down for 18 years. As the stocks kept going down the investor would have poured more and more money into stocks as his/her portfolio kept going down and down.....

Vinod

How often should an R2Ier rebalance? Because of tax defered accounts like 401K and Roth/IRA, rebalancing using the 5/25% adviced by Larry swedroe for an LIA makes sense since taxes are not triggered. But with GOI taxes would it still make sense for an R2Ier?

Also Ideally Bond portion for an R2Ier would be in Rs. In that case how should one go about rebalancing? would directing the dividends to a money market and using those for rebalancing, a good idea?

Thanks,