How often should I rebalance?

I was originally going to write this post on how to maximize returns through rebalancing.  My underlying assumption was that rebalancing helps your portfolio by “buying low and selling high,” and that I only needed to figure out the best rebalancing interval (monthly, yearly, etc.) that would maximize my returns. Through my research, however, I was able to have some sense knocked into me by a couple of enlightening articles, and one fantastic quote by a Vanguard research report “Best Practices for Portfolio Rebalancing”  July, 2010:

“It is important to recognize that the goal of portfolio rebalancing is to minimize risk (tracking error) relative to a target asset allocation, rather than to maximize returns.”

This was such a great reminder for me.  The whole point of rebalancing is to make sure your portfolio reflects the level of risk that you are comfortable with.  If at the outset, you say you want 60% stocks and 40% bonds, then even a slight 0.1% shift towards stocks means your portfolio has more risk than you want it to.  Rebalancing for any other reason than to minimize tracking error is a form of active trading, which by now, it should be pretty clear I am against.

Should I rebalance every day then? Theoretically, Yes.  In reality, No.  In reality, it usually costs money to make trades.  Even if it doesn’t (like if you have a Schwab account and only buy Schwab ETFs), making these trades takes time.  So the real question is how much tracking error are you willing to accept in your portfolio, and how much time are you willing to take to maintain it.

How often should I rebalance in reality?  The industry standard is to rebalance every year, and that is a perfectly good approach.  In the Vanguard report linked above, Vanguard has a slightly more nuanced approach that I think makes the most sense.  The report suggests that you monitor your portfolio semi-annually or annually, and only rebalance when an asset drifts more than 5% from its target percentage.  They go on to say that this approach “is likely to produce a reasonable balance between risk control and cost minimization for most investors. Annual rebalancing is likely to be preferred when taxes or substantial time/costs are involved.”

I would also suggest that you rebalance every time you add money to your account. Recently I’ve been putting money into a “house downpayment” account where I buy a number of index funds.  Since this is the type of account that I don’t make automatic deposits from my paycheck every month, I usually wait a few months and make a large contribution to portfolio and use the contribution to buy more shares of the 5 different ETFs that make up the portfolio.   Since I have to place orders anyway, I might as well make sure that my portfolio will reflect my preferred asset allocation after I finish the new trades.  This is an easy way to rebalance more than just once a year without requiring extra effort.

Does rebalancing help you get higher returns?  Ok, lets say you agree to the basic premise that rebalancing is only for the purpose of minimizing tracking error.  But does rebalancing actually get higher returns?  Is there is a rebalancing time interval (or threshold) that historically offers the best returns?  If so, then you would want to know, right?  The  answer  unfortunately depends on who you ask.

In the Vanguard study (mentioned twice and linked above), the summary states that, “Our findings indicate that there is no optimal frequency or threshold when selecting a rebalancing strategy. This paper demonstrates that the risk-adjusted returns are not meaningfully different whether a portfolio is rebalanced monthly, quarterly, or annually; however, the number of rebalancing events and resulting costs (taxes, time, and labor) increase significantly.”

Another financial advisor explains it in a different way.  The author says that when rebalancing, you are just as likely to “buy high and sell low” as it is the other way around.  He says that rebalancing can increase your returns – but only if you get the timing right.  In other words, you either have to be lucky, or trying your hand at market timing, which from my perspective is a losing proposition.  Two great posts explaining this can be found here and here.

Other researchers have tried to empirically prove that a certain method of rebalancing can increase returns, like this study by a Managing Director at TD Ameritrade. This study shows that there are “significant advantages of opportunistic rebalancing (look frequently and rebalance only when you need to) over traditional annual or quarterly rebalancing.”  In this approach, there is a complex method to determine whether you should initiate a rebalancing.  The approach outlined in the study is time consuming (it requires frequent portfolio checking) and borders on being an active trading strategy, but at least makes for an interesting read.

These three different takes are by no means an exhaustive inventory of all the views on rebalancing, but I think they are representative of the types of research you will find.  While you might find a complex method of rebalancing that can add a few basis points on your annual return, don’t forget that the point of rebalancing is simply to reduce your risk.

How often do Vanguard Target Date Funds rebalance?

I’ve been doing a lot of research lately on portfolio rebalancing and it got me wondering about Vanguard’s rebalancing strategy for its own target date funds.  After reviewing the fund’s prospectus, I decided to give Vanguard a call directly using their customer service line and ended up speaking with a representative named Robert.  I asked Robert two primary questions:

How often does my target date fund (VFIFX) rebalance?  Robert first searched through the prospectus and couldn’t find anything there so he had to place me on hold and speak with another department.  When he came back he told me that Vanguard rebalances daily just by properly managing the money coming into the fund from new investors/re-investors and the money going out of the fund from withdrawals.  He also told me that if the portfolio skews more than 2 or 3 percent from its target allocation, the fund will actively buy or sell shares of its underlying holdings to rebalance.  I pressed Robert on this point by asking him if it was an automatic 2% trigger or if the fund would only make an active adjustment during set time periods.  In other words, did the manager check the fund every quarter and only rebalance if the assets were more than 2% off, or would the manager rebalance any time the the assets were 2% off – even if it meant making trades every other day (like in a volatile market)?

Robert’s response to this was interesting – although in retrospect unsurprising.  He said that Vanguard does not release that information because of the potential for abuse.  If it was public knowledge that Vanguard rebalanced its funds on certain dates, then traders could take advantage of that fact by manipulating the price of the underlying funds that the VFIFX would have to buy in order to rebalance (In this case, VFIFX has 3 underlying funds: the Vanguard total stock market index, the Vanguard total international stock market index, and the Vanguard total bond index).  I’m not entirely sure how someone could benefit from this knowledge, but I’m guessing it is related to the ways in which a hedge fund manager can manipulate stock prices.

Does my target date fund shift its asset allocation on a continuous basis?  Robert pointed me to the graphic on the Vanguard Target Retirement fund site (which I’ve also linked to in previous posts).  When you click on a fund under the heading  “Decide which fund is right for you,” you will see a graphic similar to the one below.  This particular graphic corresponds to the 2050 fund (VFIFX).

As you move the slider left or right, it will tell you the asset mix that the fund will have at that time.  My question to Robert was whether the asset allocation changed continuously as the graph indicates (meaning a smooth line), or if it changed at stepped intervals – like every five years that corresponds to the Target fund offerings (there is no target date fund for 2051).  Robert said that the graphic essentially represented how the allocations would change, but didn’t go into much further detail.

I took a screenshot below showing the allocation change that occurred by moving the slider slightly to the right.  From what the graph tells me (by playing with the slider for a few minutes) the asset allocation changes every year. Presumably that is the answer – Vanguard Target Date Funds adjust their allocation every year.  Although, conceivably Vanguard could adjust the allocation daily by hundredths of a percent to create an even more continuous risk reduction instead of adjusting just once a year.

What is the best way to invest money for 5 years?

Like many people around this time of year, I received a nice little check from the IRS for my 2011 tax return.  I started thinking of all the things I could do with the extra money – a 47″ plasma TV, maybe an iPad, or  some new ice hockey goalie equipment.  You know, the important things in life.  Also on the list of things I want, however, is a luxury condominium with a sweet view of downtown.  Except that costs more than any tax return that I will ever see.   I figure I’ll be ready to buy a home in about 5 years (because 5 year plans never go wrong) and as a result, it is probably about time that I start saving for it.  So I decided to put my big screen TV hopes on hold and put the tax return money towards my future home.  But that was as far as I got before I realized I didn’t know where to put it.

Where should I put money that I need in 5 years?  The 5 year investment is tricky, because it is short enough that you can’t afford the stock market risk like you can with a 20 year investment horizon, but long enough that it would be silly to let it sit in a non-interest bearing account.  There are a couple of basic options out there.  There are your standard savings and rewards checking accounts, Certificates of Deposit (CDs), and finally, investment accounts.  These days savings accounts won’t get you much more than 0.75% APY, and even the best 5 year CD will only get you 1.80% APY – all according to bankrate.com.  (Also check out Smartmoney.com’s take on the best short term investments).  These options don’t even keep up with inflation, so 5 years from now your spending power will actually be reduced as a result of putting your money in these low yield accounts.  If you want the chance of earning interest greater than inflation, you are stuck with investment accounts – which is kind of scary.

At least with the savings accounts or CDs you know that in 5 years your money will actually be there.  But if you invest in stocks and the market goes bad… that luxury condo you’ve been dreaming of quickly turns into a suburban town home.  Just because you open an investment account, however, doesn’t mean that you have to invest in all stocks.  In fact, you probably shouldn’t.  As described in the my asset allocation post, a sound retirement portfolio will include bonds and treasury notes in addition to stocks.  Those who are 40 years from retirement can afford to take on much higher risk (because they have a long time to make up potential losses) and are recommended (according to Vanguard’s target date funds) to invest in 90% stocks and 10% bonds.  Those who are only 10 years from retirement are recommended to invest 66% stocks, 32% in bonds and 2% in cash. You can see the increase in bonds (in blue) as you get closer to the retirement goal in the graphic below from Vanguard’s website.

What asset allocation is best for a 5 year investment?  When I started thinking of the Target Date Fund’s progression to less risky assets, it suddenly hit me.  The 5 year investment is an awful lot like your target date fund investments when you are in retirement.  And think about it: When you are in retirement you certainly can’t afford for your nest egg to take a big hit in the market, but you need continued appreciation to try and live off the nest egg’s interest.  So what exactly does an in-retirement asset allocation look like?  I went straight to Vanguard’s website and copied down the asset percentages for the 4 funds shown below.  On the chart, the risk and expected rate of return decreases from left to right.  I’ve included two target date funds that have a target retirement date close to 2012 just as a comparison, but it is the allocation percentages from the Vanguard In-retirement fund (VTINX) that you will want to use.  While I was looking on the website I came across Vanguard’s “Life Strategy” funds, which believe it or not, have a fund specifically designed for 3-5 year investment horizon (VASIX).  This would also be an reasonable asset allocation, though it is more conservative than VTINX;   likely due to to the fact that that it is meant to be used to save for something as soon as 3 years away.

What kind of return can I expect from these funds? Keep in mind that because this is an investment in the stock market and bond market, there is no way to predict your annual yield over 5 years.  BUT, based on the asset types in each fund we can make an educated guess about what kind of returns to expect over the long run – like 20 plus years.  I know in some ways that is not helpful because we are looking at a 5 year window, but that is the best we can do; it is impossible to predict an investment’s 5 year return with any accuracy.  With that said, over the long run, I figure that these funds will average a 4% return annually.   Why is that? The goal of most in-retirement funds (at least Vanguard’s) is to get a 4% return.  The idea is that while in retirement, you can spend 4% of your nest egg every year, but by earning 4% through investments, your nest egg never loses value.  Since Vanguard advocates for using the 4% rule in retirement planning calculations, I have assumed that their retirement investments (such as VTINX) are structured to provide roughly the same return.  As it turns out (see graph below) VTINX has actually averaged a 5.30% average annual return since its inception (which was only 8 years ago so the numbers don’t mean that much).

Morningstar.com provides the actual (not average) annual return in each year since 2003.  This look shows how volatile the annual yield can be, ranging from  negative 10.93% in 2008 to a positive 14.28% return in 2009. What I’m trying to say is this:  if you invest in VTINX and keep it for 30 years, your average annual return would probably be around 4%.  However, it is entirely possible that for the 5 year window between 2012-2017 (when you own the fund) the fund would have an average annual return of 10%, or even 1%.  It is riskier than a CD, for sure,  but it is certainly well managed risk.  And besides, 4% return on my investment sounds pretty good to me, especially when I can only get 1.8% with a CD.

OK. You’ve convinced me.  But I don’t have an investment account, so what do I do? It is pretty easy:

  1. Open a Vanguard or Schwab investment account.  Make sure that you are opening an investment account and not a retirement account like an IRA, Roth IRA or 401(k).  Why those two firms? Both Vanguard and Schwab allow you to buy their brand of ETF index funds (which have the lowest expense ratios) for free.  FOR FREE!  There are no other investment firms out there with this kind of access to index funds, and as explained in my Target Date Fund Series, I think buying index funds (not individual stocks) is the smartest thing you can do.  In addition I’m consistently impressed with the advice and service that I get from both these firms (yes, I have accounts at both).
  2. If you open a Vanguard account and are going to invest more than $1,000, then you can simply buy the VTINX ($1,000 minimum) or VASIX ($3,000 minimum) fund mentioned above.  If you are starting out with less money you will have to buy 3 or 4 index fund ETFs to mimic the asset allocation of either VTINX or VASIX.  But don’t worry, I’ve made it easy for you – take a look at the chart at the bottom of the post.  It gives you the symbol of the ETF you should buy (right hand side) along with the percentage of your investment that you should spend on each ETF.   Two quick notes if you want to mimic the VTINX asset allocation: First, To put 5% in cash, you won’t have to buy a particular fund, just leave 5% of your savings unspent in the account.  Second, if you have a Vanguard account they don’t have an ETF for inflation protected securities, so just put that extra 20% in the BND fund.
  3. Keep adding to your investment account (use the same percentages detailed in step 2).
  4. Rebalance every year.
  5. Buy a home! (or whatever else you have been saving for)

3. Asset Allocation

This is part three of seven in my attempt to explain how you should invest in your retirement portfolio.  Click here for part two.

At this point I was feeling pretty good.  I had just discovered an irrefutable truth about investing that not many people knew –  and it was actually going to make me money.  I was going to buy an index fund instead of a mutual fund and ride the market’s performance all the way until retirement.    Except its not quite that easy, because you can’t just buy one index fund.  One of the main points that was pounded in my head through all my research was that you can’t have have all of your retirement money in stocks.  In order to have a safe retirement portfolio, you must have your money in more than just one asset class.  An asset class is a group of securities (things you can buy on an exchange) with similar risk and rate of return characteristics.  For example, investors often refer to stocks, bonds and cash equivalents as the three main asset classes (some might also include Real Estate and Commodities).   Stocks have the highest risk and the highest return, cash equivalents are the lowest risk, but also have the lowest returns.  Bonds are somewhere in the middle.   The main reason to have different assets is to reduce the risk of your portfolio.  If you have a portfolio of all stocks, and the market crashes, you are out of luck.  But if the market crashes and you own bonds as well, your portfolio won’t lose as much value.  That is the very basic explanation of asset allocation.  Another benefit to having different asset classes (also known as diversifying your portfolio) is that when you rebalance your portfolio, you are guaranteeing that you are selling high and buying low.  More on that in Part 6.

How should I divide up my retirement money? As a young investor, the conventional wisdom says that you want 80-90% of your retirement money in stocks and the rest in bonds.  As you get closer to retirement you will want more money in bonds and in cash (the safer investments) so that you can preserve the money you saved.  There is a whole science out there about the best way to allocate your assets which I am only skimming the surface of.  In fact, most of the experts have a much more nuanced view of asset allocation.  It is not just about stocks and bonds, but about certain categories of stocks and certain kinds of bonds.   Richard Ferri’s book, The ETF Book, recommends the following asset allocation for “early savers.”

  • 25% – Total US Stock Market
  • 15% – Small Cap Value Stocks
  • 5% – Micro-Cap Stocks
  • 10% – Real Estate
  • 10% – Pacific Rim Stocks
  • 10% – European Stocks
  • 5% – Emerging Market Stocks
  • 10% – Total US Bond Market
  • 5% – Inflation Protected Bonds
  • 5% – High-Yield Corporate Bonds

That is 10 different asset categories!  More generally, however, it is 80% stocks (55% US, 25% International) and 20% Bonds.  Compare that allocation to Ferri’s suggestions for those who are about to retire.  The generalized allocation is 50% stocks (35% US, 15% International), 45% Bonds and 5% Cash:

  • 23% – Total US Stock Market
  • 7% – Small Cap Value Stocks
  • 0% – Micro-Cap Stocks
  • 5% – Real Estate
  • 6% – Pacific Rim Stocks
  • 6% – European Stocks
  • 3% – Emerging Market Stocks
  • 30% – Total US Bond Market
  • 10% – Inflation Protected Bonds
  • 5% – High-Yield Corporate Bonds
  • 5% – Cash

Can I find a fund for each of these asset categories? When I first looked at this list, I thought it would be impossible to find funds for some of the more interesting categories like “Inflation Protected Bonds.”  Fortunately for us, you can buy an index fund for every one of these asset classes.  It didn’t always used to be this way.  In fact, it wasn’t until 1975 that the first index fund was created by Vanguard as a mutual fund.  And it wasn’t until 1993 and the creation of ETF’s that enabled  you to buy an index just like you would buy a stock. Check out the link for more information of how ETFs work.  Personally, I like to think of ETFs as mutual funds but with ticker symbols.

You’ll notice that index funds can be both mutual funds and ETFs.  There is a great article by the Motley Fool explaining the differences in detail.  While they perform the same function and will generate the same returns (not accounting for any fees), there are differences in their underlying mechanics and the ways in which you can buy mutual funds and ETFs.  With mutual funds, you buy your shares at the end of every day.  There also may be a minimum amount you must invest to enter the fund.  With ETFs you buy a share of the index fund just like you would buy a stock.  For example, to buy the Ishares (a brand) S&P 500 index fund, you would search for ticker symbol “IVV” and place an order, which would be subject to any commissions that you get charged for trading stocks.  Most of the index funds out there today are ETFs and because they have ticker symbols they are often more easily bought and sold than mutual funds that you may only be able to buy if you have a certain company’s brokerage account.

It is important to note that not all index funds are benchmark indexes – or indexes that are meant to track the performance of a market.  Generally, when speaking about index funds – as I have in previous sections – investors are referring to benchmark indexes.  Strategy indexes are index funds that use analysis or strategy to pick stocks in their index and are not meant to track the market.  For example, there could be a strategy index ETF that uses a screen so that only stocks of socially responsible companies are in the index.  Another strategy index may use a complex mathematical formula to constantly buy stocks that exhibit certain price trend characteristics.

Strategy index ETFs like these outnumber benchmark indexes by 2 to 1 in ETF market (according to Ferri’s The ETF Book), but from my point of view they are not something that you want in your retirement portfolio.  Because strategy indexes are attempts to beat the market, they should be treated the same way as actively managed mutual funds and should have their performance compared to the market’s performance.  While there have been no studies (that I have seen) measuring performance of strategy indexes against the market, I am willing to bet that their performance is about the same as mutual fund performances – which as you will recall from part 2, is not very good. Furthermore, if you agree that having proper asset allocation in your retirement portfolio is important, then strategy index funds will not work for you.  It will be impossible to tell if your strategy index (that is based on some computer model with stocks that change every day) will have the proper ratio of micro cap to small cap to emerging market stocks.

How do I actually buy these different asset categories? At this point, I knew I didn’t have all the specifics, but I had a general plan for how I was going to actually fund my retirement account.  As I saw it, the first step was to find an ETF benchmark index that matches the asset categories I was looking for.  Once I found an ETF for each of the 10 categories listed above (for a young investor), I would buy each of the 10 ETFs every time I put money into my retirement portfolio.  I would make sure that the amount of money I had in each ETF was equal to the percent that recommended in the preffered asset allocation.  Lets say each ETF cost $1 a share (in reality the Bond Index ETF might cost $21.63 a share and the Emerging market Stock Index might cost $84.16 a share) and I had $100 to put in my retirement portfolio.  I would buy 25 shares of the Total Stock Market ETF, 15 Shares of the Small Cap Stock ETF, 5 shares of the Micro Cap stock index and so on…  In a case where all the shares were $1, except for the Total Stock Market ETF which was $25, I would buy just 1 share of the Total Stock Market ETF.  Its not the number of shares that count, but the amount of money in each category.

My retirement plan was finally starting to come together – that was until I realized that there was more than 1 ETF for every index I was looking for.

To continue reading, follow the link to Part 4 – Expense Ratios.