PP expected return

[kka]

Sure, the non-rebalanced 50/50 portfolio beat the rebalanced over 69 years -- no surprise, since it was > 90% stocks for the last 40 years.  Considering both risk and return, there was a rebalancing bonus for that period.  The average return of 50/50 stocks/bonds for that period is 7.85%, but the rebalanced allocation returned 8.34%.

If the only two assets considered are stocks and bonds, and if stock returns are always higher than bond returns over long time horizons, then obviously buy and hold, as well as portfolio insurance, will produce returns superior to rebalancing. As already pointed out, this will come at the cost of gradually increasing portfolio risk. However, things are very different when looking at global equity portfolios. Over very long time horizons there is usually relatively little difference in the returns in most national equity markets; under such circumstances rebalanced portfolios dominate. For example, when looking at the 1970-94 period, rebalancing various asset pairs almost always provides returns superior to nonrebalanced porfolios. Only when long term return differences among asssets exceed 5 percent do nonrebalanced portfolios provide superior returns, and then only at the cost of increased risk.

[Kshartle]

Sure, the non-rebalanced 50/50 portfolio beat the rebalanced over 69 years -- no surprise, since it was > 90% stocks for the last 40 years.  Considering both risk and return, there was a rebalancing bonus for that period.  The average return of 50/50 stocks/bonds for that period is 7.85%, but the rebalanced allocation returned 8.34%.

Yes and the non-rebalanced was 9.17%

If you're arguing that re-balancing results in a higher likelihood of a better return vs. volatility ratio that's subjective of course, but I would suspect it's probably the case for most investors.

Like I said, re-balancing is a good idea. If diversification is important to you to start with then it makes sense you'd want to maintain it over time. This is particularly true because it's more likey that safety is more important the older you get.

There's just no magical bonus to our returns from it, unfortunately. This is what a lot of people here think as this topic comes up frequently. I point out it's not the case just so they understand that, not to pee in their cheerios. I'll leave to anyone else though since now pretty much everyone should understand it at this point.

[kka]

The non-rebalanced return was higher because it wasn't a 50/50 portfolio for very long.  It probably averaged more like 80/20.

There really is a rebalancing bonus, also called a diversification return.  More detail here:

http://papers.ssrn.com/sol3/papers.cfm? ... id=1898864

http://www.jstor.org/discover/10.2307/4479541

[Kshartle]

The non-rebalanced return was higher because it wasn't a 50/50 portfolio for very long.  It probably averaged more like 80/20.

There really is a rebalancing bonus, also called a diversification return.  More detail here:

What is a non-rebalanced portfolio but one that doesn't stay balanced?

Ok. You are stating conclusively that rebalancing adds to returns. You must have a theory as to why it hasn't added to returns over 33 years. How many more years until it appears and stays forever?

[kka]

When you take risk and return into account, there was a rebalancing bonus even for that period.  An unrebalanced PP had a higher return over that period, but higher risk as well.  A rebalanced PP's return is higher than the average return of its constituent assets because of diversification return.  The SSRN paper concludes, Diversification return might be described as the "free dessert," as it is an incremental return earned while maintaining a constant risk profile.

[Xan]

Right, but we haven't been talking about a rebalancing bonus for a given risk profile; this discussion has been about an absolute rebalancing bonus, unless I've completely misunderstood.

That's what Kshartle has been saying all along: that there are many other good things about rebalancing, primarily in maintaining a good risk profile, but a guaranteed bonus is not among them.

[stuper1]

The word "bonus" needs to be taken in context.  The original post was looking at the average returns of the 4 asset classes and trying to figure out the expected return in the future.  From the data posted, it appears that someone who rebalances say at 15/35 can expect a "bonus" above just the average of the 4 average returns.  Albeit their returns may well be less than if they didn't re-balance at all.

[Kshartle]

The word "bonus" needs to be taken in context.  The original post was looking at the average returns of the 4 asset classes and trying to figure out the expected return in the future.  From the data posted, it appears that someone who rebalances say at 15/35 can expect a "bonus" above just the average of the 4 average returns.  Albeit their returns may well be less than if they didn't re-balance at all.

Well this seems like a silly discussion then. Unless you're talking just one year.....you would never get the arithmetic mean between the average annual returns of the asset classes. I'll not bother posting the math but anyone is free to disprove.

When I re-read the posts it looks like people actually believe they can count on some kind of additional absolute returns by just re-balancing. In fact I know there are people who think this but sadly, and I do mean sadly, that's just not correct. Re-balancing might prove better over a certain time period or it might not, there's no way to know in advance. I think the evidence is overwhelming that over longer periods, re-balnacing is likely to lead to lower returns because stocks, by their nature, should outperform all others over the long long run as well as missing out on letting your investments run during super-bull markets.

[Tortoise]

The word "bonus" needs to be taken in context.  The original post was looking at the average returns of the 4 asset classes and trying to figure out the expected return in the future.  From the data posted, it appears that someone who rebalances say at 15/35 can expect a "bonus" above just the average of the 4 average returns.  Albeit their returns may well be less than if they didn't re-balance at all.

Average of the 4 average annualized returns = what you get if you buy 4x25% and never rebalance.

Average of the 4 average yearly returns = what you get if you rebalance every year on Jan 1.

Remember, average yearly return is an arithmetic mean. Average annualized return is a geometric (multiplicative) mean.

So doesn't the Geometric vs Arithmetic Mean Inequality (http://en.m.wikipedia.org/wiki/Inequali ... tric_means) imply that there must always be a non-negative absolute rebalancing bonus? If that inequality doesn't apply here, can someone point out why? Also, if it doesn't apply, can we think of a simple counterexample that shows it doesn't work?

EDIT: I don't think the inequality applies after all, because in the rebalanced case, the average return of each asset is a function of all the others. So a counterexample would be if three of the assets plummeted to zero each year and the 4th one held steady. In that example, the rebalanced portfolio would disappear over time and the non-rebalanced one would retain 25% of its value. Darn.

[Kshartle]

The word "bonus" needs to be taken in context.  The original post was looking at the average returns of the 4 asset classes and trying to figure out the expected return in the future.  From the data posted, it appears that someone who rebalances say at 15/35 can expect a "bonus" above just the average of the 4 average returns.  Albeit their returns may well be less than if they didn't re-balance at all.

Average of the 4 average annualized returns = what you get if you buy 4x25% and never rebalance.

Average of the 4 average yearly returns = what you get if you rebalance every year on Jan 1.

Remember, average yearly return is an arithmetic mean. Average annualized return is a geometric (multiplicative) mean.

So doesn't the Geometric vs Arithmetic Mean Inequality (http://en.m.wikipedia.org/wiki/Inequali ... tric_means) imply that there must always be a non-negative absolute rebalancing bonus? If that inequality doesn't apply here, can someone point out why? Also, if it doesn't apply, can we think of a simple counterexample that shows it doesn't work?

I've gotta ask T......since there is no "bonus" for rebalancing against a non-rebalancing portfolio that we can count on, and if you re-balance you obviously make it impossible to get the uhhhhhh mean of the average annualized return of the four assets.......what is there to get a bonus against?

There is no action to be taken based on this concept and no way to improve returns with any certainty over just buying and holding and any "bonus" is against some theortical return that you would never get anyway. It's just a way to position the concept of rebalancing as a way to boost returns when it in fact does not boost them in any way.

[Kshartle]

The word "bonus" needs to be taken in context.  The original post was looking at the average returns of the 4 asset classes and trying to figure out the expected return in the future.  From the data posted, it appears that someone who rebalances say at 15/35 can expect a "bonus" above just the average of the 4 average returns.  Albeit their returns may well be less than if they didn't re-balance at all.

Average of the 4 average annualized returns = what you get if you buy 4x25% and never rebalance.

Average of the 4 average yearly returns = what you get if you rebalance every year on Jan 1.

Remember, average yearly return is an arithmetic mean. Average annualized return is a geometric (multiplicative) mean.

So doesn't the Geometric vs Arithmetic Mean Inequality (http://en.m.wikipedia.org/wiki/Inequali ... tric_means) imply that there must always be a non-negative absolute rebalancing bonus? If that inequality doesn't apply here, can someone point out why? Also, if it doesn't apply, can we think of a simple counterexample that shows it doesn't work?

I've gotta ask T......since there is no "bonus" for rebalancing against a non-rebalancing portfolio that we can count on, and if you re-balance you obviously make it impossible to get the uhhhhhh mean of the average annualized return of the four assets.......what is there to get a bonus against?

There is no action to be taken based on this concept and no way to improve returns with any certainty over just buying and holding and any "bonus" is against some theortical return that you would never get anyway. It's just a way to position the concept of rebalancing as a way to boost returns when it in fact does not boost them in any way.

To put it more simply, your only choices are re-balance or don't re-balance. If you cannot ensure superior returns by re-balancing, then there cannot be a "bonus" for doing so. At least not a "bonus" with regards to returns, only to risk/reward depending on your risk/volatility tolerance.

[Tortoise]

I agree, Kshartle. Shortly before you responded, I went back and edited my post to say that my mathematical intuition was wrong.

I agree that rebalancing does not guarantee a bonus, but there are cases when it happens to beat not rebalancing. One just can't predict with certainty when those cases occur.

So I agree that rebalancing is to keep a constant risk profile, not to get a guaranteed benefit (since it doesn't exist).

[Kshartle]

I agree that rebalancing does not guarantee a bonus, but there are cases when it happens to beat not rebalancing. One just can't predict with certainty when those cases occur.

Yes I wish I had a crystal ball but instead I've just got two squishy ones.

Appreciate the nimble mind.

Perhaps the bosses can slap this in the FAQ....no re-balance bonus! I feel bad always being the grinch that stole Xmas when this topic is brought up.

[buddtholomew]

How do we reconcile a belief in reversion to the mean and the absence of a rebalancing bonus to increase returns. Do I need to worry about having the intestinal fortitude to rebalance into a declining asset when it breaches the 15% threshold or forget about re-balancing altogether? I may end up re-balancing with new money only.

[Tortoise]

Budd, I just think about it like this: If any of my assets exceed 35% of my portfolio, I'm really going to be hurting if that asset tanks. And if any asset falls below 15%, I'm really going to be kicking myself if it rockets into the stratosphere tomorrow.

Keeping things near 25% just protects me from those two extremes, and that's why I do it.

[Kshartle]

How do we reconcile a belief in reversion to the mean.......

Read Browne's book "Why the best laid Ivestment Plans......" page 187 and the gold/silver ratio reversion to the mean principle to cure you of this.

[Tlagnhoj]

Return for a given amount of risk is the only kind of return that is relevant for comparison purposes.

When compare return for risk taken, the data clearly shows a superior result when rebalancing.

Further, the logic is supportive when understanding the combined facts of 1) cognitive biases and 2) substantial underperformance to indices/benchmarks across all asset classes and from most investors (both individual and professional).

Rebalancing discipline essentially has you buying an asset when others are panic selling, and selling when others are greedily chasing to buy. It's not coincidence that this is part of the same reason why warren buffet has enjoyed such outsized returns over such a long time period (not the only reason, but certainly one of the key ones). As he himself states, buy when others are fearful, sell when others are greedy. For the average investor, it is only feasible to do that it you have both 1) diversification by asset class/economic outcome type and 2) a systematic way to do it which helps to avoid the emotional influence which will by definition be high at those times.

The fact that even with those 2 components, it's hard for most people to understand, believe in, and follow through on means that the advantage to doing it is likely to be persistent.

[portart]

“He who is not contented with what he has, would not be contented with what he would like to have.”?
-Socrates

[Libertarian666]

Rebalancing discipline essentially has you buying an asset when others are panic selling, and selling when others are greedily chasing to buy. It's not coincidence that this is part of the same reason why warren buffet has enjoyed such outsized returns over such a long time period (not the only reason, but certainly one of the key ones). As he himself states, buy when others are fearful, sell when others are greedy. For the average investor, it is only feasible to do that it you have both 1) diversification by asset class/economic outcome type and 2) a systematic way to do it which helps to avoid the emotional influence which will by definition be high at those times.

My understanding is that WB's longterm market outperformance is actually due to exactly one transaction: his purchase of GEICO. Certainly his investing "genius" has been crushed over the last 15 years by an "inert lump of metal", even with the recent correction of the latter's price.

[frommi]

My understanding is that WB's longterm market outperformance is actually due to exactly one transaction: his purchase of GEICO. Certainly his investing "genius" has been crushed over the last 15 years by an "inert lump of metal", even with the recent correction of the latter's price.

I think you are clearly the better investor! But wait, why are you not a billionaire?

[Libertarian666]

My understanding is that WB's longterm market outperformance is actually due to exactly one transaction: his purchase of GEICO. Certainly his investing "genius" has been crushed over the last 15 years by an "inert lump of metal", even with the recent correction of the latter's price.

I think you are clearly the better investor! But wait, why are you not a billionaire?

Who said anything about my investing ability?

[frommi]

Who said anything about my investing ability?

Certainly his investing "genius" has been crushed over the last 15 years by an "inert lump of metal", even with the recent correction of the latter's price.

That sounds that you pretend to be the better one, if it wasn`t meant that way forget my post. Otherwise make a reality check. 
When you are able to get 30% returns 12 years in a row, you can speak that way about WB. If not shut up. 

When you want to learn about WB:

http://beginnersinvest.about.com/cs/war ... timeln.htm

Returns:
http://en.wikipedia.org/wiki/The_Superi ... Doddsville

Don`t feel pissed now, but i don`t like it when people speak/write respectless about great and honest people. 

[Xan]

Why are all your apostrophes backwards?

[dualstow]

Why are all your apostrophes backwards?

I believe those are called catastrophes, as the etymological meaning is "the opposite of what is expected".

[Libertarian666]

Who said anything about my investing ability?

Certainly his investing "genius" has been crushed over the last 15 years by an "inert lump of metal", even with the recent correction of the latter's price.

That sounds that you pretend to be the better one, if it wasn`t meant that way forget my post. Otherwise make a reality check. 
When you are able to get 30% returns 12 years in a row, you can speak that way about WB. If not shut up. 

When you want to learn about WB:

http://beginnersinvest.about.com/cs/war ... timeln.htm

Returns:
http://en.wikipedia.org/wiki/The_Superi ... Doddsville

Don`t feel pissed now, but i don`t like it when people speak/write respectless about great and honest people. 

There's nothing great or honest about WB. He disowned his granddaughter for speaking out about their lives more frankly than he liked. He also gets plenty of sweetheart deals like special bonds that other people can't buy, e.g., http://blogs.wsj.com/deals/2011/08/25/w ... f-america/

And he still can't beat an "inert lump of metal" over a 10- to 15-year holding period.