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³Everyone¶s Got A Plan´

If you have $1 what do you do with it? How about $1000 or $10,000 or more? You only have
two choices; you can either spend it or save it. If you save it you can put it in your pocket,
you can bury it in the back yard, put it under a mattress or Ô


. Because most
people correctly recognize that anything other than investing it means they will lose the
ability to preserve purchasing power due to inflation they choose to invest it. If you invest it
you must decide how to invest it. This means you will invest it in something. This something
is called an asset and they come in many forms but in my opinion there are only three ³Core
Asset Classes.´ They are stocks, short-term investment grade bonds and longer-term
investment grade bonds. We are familiar with stocks but maybe not so familiar with bonds.
Short-term investment grade bonds are commonly referred to as cash and have maturities of 1
year or less. Most people recognize them as money market funds. Longer-term investment
grade bonds are commonly referred to as bonds and mature in more than 1 year. With these
three building blocks of stocks, cash and bonds an investor can work wonders.

Asset classes that do not fall into one of these two categories I consider non-core. In the
hands of the most sophisticated of investors these non-core asset classes can add value to a
portfolio. However, seeing these types of non-core assets in real portfolios over the last 30
years tells me that for the vast majority of investors they are counterproductive. The reason of
course is that people don¶t know how to use them correctly. In the wrong hands, these non-
core assets do more harm than good. Some examples of non-core asset classes include real
estate, commodities, natural resources, currencies, high yield bonds and options. This tale
focuses on the big three core classes. I think investors have their hands plenty full just dealing
with these three.

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     we learned that the most crucial decision an investor must make
is determining if they want to even have a diversified portfolio of stocks as well as a
diversified portfolio of bonds or some combination of the two. If the decision, which I highly
encourage, is to diversify using stocks and bonds then the next critical question is how much
should I have in a diversified portfolio of stocks and how much in a diversified portfolio of
bonds. This is the asset allocation decision. Investing is just another term for allocating your
capital. It is the second most important decision about investing after the will I or will I not
choose to diversify.

Let¶s look at some examples. If Investor A chooses to put all their money in a single stock
such as General Electric, he has made two decisions. He has chosen to not diversify and he
has chosen to allocate 100% of his money to stocks since General Electric is a stock. If
Investor B chooses to put all their money in an exchange-traded fund such as SPY, he has
also made two decisions. He has chosen to diversify and he has chosen to allocate 100% of
his money to stocks. The reason Investor B is diversified and Investor A is not is because by
investing in SPY, Investor B has chosen to invest in a diversified portfolio of stocks while
Investor A has invested in only one stock. Nevertheless they are both 100% allocated to the
stock market. The same reasoning we used for stocks can be used for bond investing. This
leads to the logical conclusion that ³You can¶t make an investment decision without making
an asset allocation decision.´ Investing and asset allocation are one and the same. Asset
allocation is nothing more than the slicing and the dicing of your money. Asset allocation is
the percentage of your money that is allocated to different asset classes so that it adds up to
100%.

Let¶s construct a simple portfolio with our three core asset classes. If you allocate 60% of
your money to stock investments, 30% to bond investments and 10% to cash investments you
have created an asset allocation that includes all three. A portfolio like this might be called a
60/30/10 portfolio to reflect the individual pieces. This is a good way to look at any portfolio.
If the 60% stock piece is invested in a diversified portfolio of stocks and the 30 piece is
invested in a diversified portfolio of bonds and the cash piece is safe and plays the role that
cash is designed to play in a portfolio then the investor with a 60/30/10 can expect to make
rates of return that are within historical parameters while taking risks that are also within
historical parameters. But what if the investor chooses not to diversify?

Lets look at an example of an asset allocation where the investor has a 60/40/0 portfolio that
is dangerous and misses the objective of asset allocation. I stumbled upon an investor in my
travels that said he had a 60/40 portfolio. I was impressed with his ability to recognize and
quantify his holdings. Most people can¶t or don¶t know the importance of asset allocation.
This guy knew however somewhere along the way he missed the point about diversification.
I asked him to explain and he said that he had 60% of his money in a small stock I had never
heard of and the other 40% in a bond I had never heard of either. This guy knew the lingo,
did in fact have a 60/40/0 asset allocation, but he didn¶t have a firm grasp of the implications
behind the term asset allocation. Implicit in the term asset allocation amongst academicians
and professional investors is the notion that a portfolio is diversified. Since this fellow lacked
diversification because he only owned one stock and one bond, he was missing the benefit of
diversification. He was right but he was wrong. Most importantly, his expected returns and
potential losses were not the same as the investor that chose to asset allocate while employing
diversification as well.

Now that we know the 3 ³Core Asset Classes´ we can learn a bit more. When people speak
of asset allocation they might say they have a 40/60 or 50/50 or 60/40 or 75/25 or 90/10
portfolio. In every case the first part is the portfolio allocation to stocks and the second part is
the allocation to bonds and cash. Bonds and cash are typically lumped together and is
something you should be aware of but not how you should look at your portfolio since cash
and bonds have different return and risk characteristics. Nevertheless this is the way asset
allocation has evolved when people talk about portfolios. This lumping together effectively
leaves us with just 2 ³Core Asset Classes´ which are commonly referred to as simply stocks
and bonds. So when I met the investor that said he had a 60/40 portfolio I immediately
assumed he had a diversified portfolio that had 60% allocated or invested in stocks and 40%
allocated or invested in bonds. Had he told me he had a 75/25 portfolio I would have assumed
he had 75% invested in stocks and 25% invested in bonds. Learn this lingo because it¶s
universal.

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Let¶s build a diversified portfolio with just the stock and bond ³Core Asset Classes.´ We
need to give them some characteristics. In the stock class we will use the S&P 500 as a
representation of the stock market and in the bond class we will use the Barclay¶s Aggregate
as a representation of the bond market. With just these two you can build a diversified
portfolio because with these two investments you are effectively investing in hundreds of
stocks and bonds. Let¶s pick an actual investment that we can utilize. Let¶s pick the exchange
traded fund SPY for the stock market and AGG for the bond market. Let¶s examine some
characteristics of each of these. For this example, SPY should make the investor about 10%
annually and AGG should make about 5% over the long run based on historical returns. In
addition at times SPY might make as much as 50% or lose as much as 50% in a year. AGG is
much tamer and might make as much as 20% or lose as much as 10% in a year. Let¶s look at
the table below and see what this means to an investor.

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(SPY) (AGG)
100% 0% 10% 50% -50%
90% 10% 9.5% 47% -46%
80% 20% 9.0% 44% -42%
70% 30% 8.5% 41% -38%
60% 40% 8.0% 38% -34%
50% 50% 7.5% 35% -30%
40% 60% 7.0% 32% -26%
30% 70% 6.5% 29% -22%
20% 80% 6.0% 26% -18%
10% 90% 5.5% 23% -14%
0% 100% 5.0% 20% -10%

This table is what I consider a highly realistic portrayal of what a person can expect to make
in any 1 year because the assumptions I made for the characteristics of SPY and AGG reflect
their approximate historical nature. We can see that when the investor told me he had a 60/40
portfolio I immediately was able to characterize him as a person that would reasonably expect
to make 8% over the long run, but that he would have at least 1 year where he made as much
as 38% that year and others where he lose as much as 34%. Thus asset allocation, though it
doesn¶t say it in its¶ name, means that once you choose an asset allocation you are targeting a
return as well as a risk level for your portfolio. Stocks provide a higher long-term return but
with more risk than bonds. Conversely, bonds will give you a lower long-term return but with
less risk than stocks.

Here comes the part that will put money in your pocket if you can execute it properly. Rest
assured it is not psychologically easy to do but if you do it you will make approximately an
additional 1% per year compared to what the table above suggests. What is it? It¶s called
rebalancing between stocks and bonds. If you don¶t know what rebalancing is I suggest you
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. Let me say one last time that if the only two investments you ever
made were in SPY and AGG and if your asset allocation is not skewed to overly aggressive
or conservative, then the proper rebalancing formula or algorithm will put about an extra 1%
per year in your pocket. For example, pick an asset allocation that¶s not overly aggressive or
conservative such as a 60/40 allocation and every time that the stock allocation reaches either
10% higher or lower you rebalance back to 60/40. My research as well as that of many others
shows that this adds almost 1% rate of return to your portfolio. In practice this means that if
the portfolio composition reaches 66% stocks, 10% higher than the initial 60%, at any time
from the last rebalancing you would sell 6% of SPY and buy AGG to get back to 60/40.
Conversely, if the portfolio composition reaches 54% stocks at any time from the last
rebalancing you would sell 6% of AGG and buy SPY to get back to 60/40.

What makes this difficult? Why doesn¶t everyone do this? The answer is human behavior and
why I consider the reconditioning or reprogramming of our evolutionary tendency to make
poor investment decisions one if not the most important aspect of successful investing. Let
me give you an example to help you understand. The subtitle of this tale is ³Everyone¶s Got
A Plan.´ I often use subtitles to help you remember the moral of a tale. In this case I use it to
help you understand the psychological difficulty of rebalancing. It is not easy to do because
while it may seem simple to think that you will act in a rational manner when the time comes
to rebalance, rest assured, most people are ill equipped because they¶ve been taken out of
their game plan. Let me draw a similarity between boxing and rebalancing. There was a time
when Mike Tyson was the greatest heavyweight boxer on the planet. In a post fight interview
after a decisive win by knockout the still undefeated champ is told by the announcer that his
next opponent has a plan to defeat Mike in their upcoming bout. Mike looks him right in the
eye and says ³Everyone¶s got a plan, till I hit them.´ It¶s the same with rebalancing.
Everyone¶s got a plan until the market hits them. It¶s easy in theory to project how you will
behave, but when you get hit by losses and fear grips your psyche it is hard to execute.
You¶ve been hit and your plan goes out the window.

As of this writing, February of 2009, most investors are in a state of fear. They are unwilling
to buy stocks or take risk. They have lost money and all they see or experience is the recent
past. They are seeking safety. They are avoiding pain and in portfolios, pain means stocks.
Yet, many of the 60/40 models I look at have signaled the purchase of stocks from the sale of
bonds multiple times from the market high of October 2007. If and only if an investor can
overcome this fear can they take advantage of rebalancing between stocks and bonds. It is
easier said than done. One last note on rebalancing. Psychologically rebalancing is
asymmetrical. What I mean by this is that it is much easier to sell stocks when they reach
66% of your portfolio than to buy them when they reach 54% of your portfolio. Fear is a
much harder emotion to overcome than greed.

You may have read studies that discuss the benefits of asset allocation. They are very
confusing to most because they make conclusions that very few people understand. They say
things like ³90% or 93% of the return that a portfolio generates is based on asset allocation.´
It¶s silly. We know that 100% of the return that a portfolio generates is based on asset
allocation. What these experts are trying to say is something else. They are trying to say that
the most important decision that a person makes is the amount they allocate to stocks vs.
bonds. I agree. There is a world of difference between allocating 100% to stocks vs. 100% to
bonds. Just look at the table for proof.

We learned that by choosing a 60/40 portfolio of SPY and AGG you will make about 8% per
year. We also learned that rebalancing between the two when they get too far away from their
original allocation increases that return by 1% so that you can now make 9% per year.
Rebalancing effectively converts a 60/40 portfolio to an 80/20 portfolio while maintaining the
risk of a 60/40 portfolio. Rebalancing is a tool you should use. Finally, examine the all-stock
allocation. It can¶t rebalance because it is always fully invested in stocks so it can¶t get the
1% boost from rebalancing. Rebalancing between stocks and bonds is after diversification the
single most important thing that the average investor can do to make money. Do it if you can.
If you can¶t, hire someone that will do it for you.
If diversification is the Wall Street version of a free lunch, then rebalancing must surely be
the equivalent of a free breakfast. I highly encourage people to fully participate in both
breakfast and lunch. Unfortunately, there are no free dinners on Wall Street.

Financial Tales has been promoting Financial Literacy since September 29, 2008.

If this tale has contributed to your financial education, financial literacy and/or financial
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2 Comments »

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Thanks for the great article. It was really informative. As an additional point, I wanted
your opinion about balanced funds like VBINX, specifically how frequently such
funds rebalance?

Also, in general what is your opinion about frequency of rebalancing?

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The question is how often should a person rebalance their portfolio and how should
they do it specifically.

Let¶s lay some groundwork before we answer the question. To properly rebalance you
must have your portfolio with a firm that can accommodate rebalancing at no cost.
You must also have a diversified portfolio as well as a target stock and bond asset
allocation that suits your situation. Concentrated, focused or individual stock
portfolios are not meant to be rebalanced so don¶t try it because it will lead to disaster.

Rebalancing works in three dimensions. The first dimension and by far the most
important is the ratio of stocks to bonds. Our research over the last 80 years using
daily data shows that almost all the benefits from rebalancing are gained in the first
dimension. This means that you should always be aware of the ratio of stocks to
bonds in your portfolio. When one gets too far ahead of the other it is time to
rebalance. The second dimension is the ratio of stock asset classes to other stock asset
classes within the portfolio. The last and third dimension is the ratio of bond asset
classes to other bond asset classes in the portfolio.

The rest of this response will focus on how to rebalance in the first dimension or the
stock to bond dimension. There are only three ways to rebalance. The first is
rebalance based on frequency or time. You rebalance every 2 weeks or every month
or every quarter or some other nonsense. Don¶t do it. This form of rebalancing does
not capture the true benefit from proper rebalancing. It does not maximize the
objective of rebalancing which is to reduce risk based on a target allocation. The
second is to do it once a year. I actually like this much better for individual investors
since it is a once a year thing and dose not require constant supervision. The third and
best method is formulaic rebalancing.

Our rule of thumb is to rebalance whenever the ratio of stocks in the portfolio
diverges from the target allocation by more than 10%. As an example, for a 50/50
portfolio whenever stocks are either 45% or 55% of the portfolio we rebalance. For a
60/40 portfolio whenever stocks are either 54% or 66% of the portfolio we rebalance.
Please note that if you have a 100% stock or bond portfolio you can¶t rebalance in the
first dimension and you lose the effectiveness of rebalancing. It is an obvious point
but important. It is one of the main reasons why you see very few portfolios with
allocations in excess of 80% in stocks or with less than 40% in stocks.

If you use our 10% band for rebalancing you will find you get a signal every 8-10
months. Some periods where the markets are volatile will give you frequent signals
and others will have you go for long stretches where you do nothing. We prefer this
dynamic method for rebalancing because it takes into consideration market volatility.

Mechanically, we don¶t reinvest our dividends or interest. This means that when we
rebalance and sell an asset class we add this to our money market funds. We include
money market funds as part of our bond allocation. This leads to two more questions.
If you must rebalance because your first dimension or ratio of stocks to bonds is
outside of the target allocation band by 10% which asset classes do you sell and
which do you buy.

There are only three logical choices that you can make when selling or buying when
you get a rebalancing signal. Number 1²You can sell and buy some of each so that
the ratio of the stock and bond asset classes remains the same after rebalancing.
Number 2²You can overweight towards the leading or best performing asset class or
classes or overweight towards the lagging or worst performing asset class or classes.
Number 3²You can rebalance everything back to the original asset allocation. It is
important to recognize that at this point you are simply tweaking your portfolio. You
are now in the second and third dimension but not the most important one.
Rebalancing between stocks and bonds far exceeds the importance of individual stock
or bond asset class rebalancing.

For those that are curious²stock asset classes have a persistency effect that means
that winners keep winning and losers keep losing. Stock asset classes have a
persistency effect. This means that you will make more money if you allocate all of
your money to the asset class that is performing the best and raise money from the
 asset class that is performing the worst. I have not yet released a tale addressing this
persistency effect so for now I suggest the reader simply go with alternative Number 3
and rebalance back to the original allocation.