Balance And Diversification – Part 2

Welcome back for Part 2 where the focus will be on balance and rebalancing. If you missed Part 1, it focused on the importance of diversification in an investment portfolio and you can read more about it here

As important as it is to have diversification in an investment portfolio, things still need to be balanced and regularly rebalanced. I did talk high level in a prior blog post about annually rebalancing the comparison portfolios I use to measure against my own portfolio performance. By rebalancing their weighings to their original asset allocations, I’m always measuring my own B&D portfolio against the same things, year after year.

There’s a more important reason though as well. Remember Lesson #3? Rebalancing is all about selling a portion of your winners to buy more of your losers and, in the process, adjust and minimize the undesirable risks in your portfolio while enduring stable, long term returns.

Sell your winners? To buy your losers? 

Are you cray cray, Peter?

That’s right! Well, more the former, less the latter. It’s all about Lesson #2It’s funny how these simple lessons come back, over and over again. The whole point is, what is hot and desirable today may not be tomorrow. And vice versa. This is all about trying to manage our greed by minizing emotions, stress and uncertainty.

Let me try to give a real world example. You hear on the news that the price of gas to fill up your car will drop by 10 cents a litre/gallon tomorrow. Do you buy it today at the higher price or tomorrow at the lower price? Unless your tank is practically empty, you’re buying tomorrow. Or you’ll just fill it up enough today so that you can make it to tomorrow and then fill it completely. That’s pretty simple right? Buy low. 

Here’s a more complex example. In early 2017, house prices in Canada were up a lot. Especially in the Toronto area where I lived. Some were saying it would continue going up. That it was silly to sell. Others said it was peak house prices. I owned the home I lived in at that time. I weighed things out, decided I would sell and, become a renter (gasp!). I took the net equity after paying realtor fees and redirected the funds into my investment portfolio. Thereafter, house prices did retreat a little bit but remained stable. Until the craziness of 2021. Covid, WFH, supply chain logistics problems, and cocooning made house prices shoot for the moon. In that same time though, my B&D portfolio compounded 49.90% and I created the cashflow that would allow me to retire. Sell high. 

How does this relate to rebalancing investment portfolios? 

For some, everything. For others, nothing at all.

RebalaNcing done poorly

Let’s look again at the last graph I had added in Part 1, seen below.

Both ETFs VSB and XSP are down YTD for 2022. VSB, part of the fixed income piece of my B&D portfolio forms part of the safe(r) stuff and is down a bit over 5% for this time period up to June 10th, 2022. XSP is part of the equities piece of my portfolio and has dropped nearly 17% for the same time period.

Just to keep things simple, let’s say VSB forms 40% of a portfolio and XSP makes up the other 60%. On the chart below, it shows the price, as of January 5th, 2022 (I’d like to use the closing price of Dec 31, 2021 but Google likes using the first business day of the year, go figure), the cost of a unit of VSB was $23.64 while the cost for a unit of XSP was $50.43.

Let’s assume the portfolio has a total value of $100,000 for demonstration purposes (your own portfolio could be $1,000 total and this will still apply). $40,000 going to VSB and $60,000 going to XSP. We go ahead and buy VSB at $23.64 and XSP at $50.43.

From here, we’ll play out 2 scenarios. The first will be that we rebalance the portfolio back to its initial allocations while the second scenario will be left untouched. Based on the chart below, rebalancing for the first scenario occurs March 14, 2022. Why March 14, 2022? XSP has lost about 11% of its value at that point before it shoots back up (oh the power of hindsight) while VSB has lost just about 2%.

The spreadsheet advises to sell 94 units of VSB and buy 49 units of XSP to get things back to 40% VSB and 60% XSP.

Having done that, the rebalanced portfolio now holds 1598 units of VSB and 1238 units of XSP.

Now, let’s go to March 29, 2022 where XSP has nearly regained almost all its value versus the beginning of 2022. What has been the result of the rebalancing from March 14, 2022 (note that we have the advantage of hindsight and we can all see that March 29, 2022 is the peak for 2022 before it slides back down).

The portfolio balance came in at $98,178.64. Now, let’s consider if we had done nothing for the same period.

The difference between rebalancing and doing nothing for the same period comes out to a measly $263.59 ($98,178.64 – $97,915.05). 

So, what does this mean? Is rebalancing a pointless waste of time? 

No.

It means that there’s a time and place to rebalance. Even if an ETF like XSP losses 11% of its value, that doesn’t mean you’ve met the criteria to rebalance. Now that we’ve walked through where rebalancing doesn’t add value, let’s review where it does.

Rebalancing done well

At this point, we’ll play out a alternate scenario than the one above that makes rebalancing worthwhile. I’ll also talk about the 5/25 rule. Lastly, I’ll discuss rebalancing with cashflow.

Firstly, let’s start with the alternate scenario. I’m picking a different timeframe. This one will be from December 27, 2019 to December 31, 2020. We’ll use March 20, 2020 as the rebalancing date. Again, we’ll use a $100,000 portfolio allocating 40% of it to VSB and 60% to XSP.

In this case, rebalancing yielded a return 12.30% for the period. What would have happened if we had not rebalanced March 20, 2020?

Doing nothing in this case would have yielded 8.30% which is 4% less of a yield or $4,007.09. This is significant. Most personal finance and FIRE articles that talk about what a Safe Withdrawal Rate (SWR) is will point to 4% of the value of a retirees portfolio. On the principles of the SWR, a retiree should (I say should here as there are always exceptions) never run out of money throughout the rest of their life withdrawing 4% of their portfolio to live on. 

That is…incredible! On my own B&D portfolio which started 2022 at around $1.6 million, 4% represents $64,000. How many hours does the average wage earner need to work to collect that? It’s something to think about and be grateful about. I guess that’s a good segue to Rule #5: Make your money work for you, not the other way around.

Is the above rebalancing possible? Absolutely! Done right, it can shave off years towards your financial independence as well as eventual retirement. And in retirement, it can buffer how much actually gets drawn off your portfolio each year.

So, why was the rebalancing so significant here versus the prior example earlier on?

The 5/25 rule can help explain this a bit.

THe 5/25 rule

A commenter from a previous blog post by the name of Soggy had brought up the 5/25 rule. I had been aware of this rule previously and, as a rule of thumb, explains well why rebalancing works in certain cases and not in others. I pulled up an article from MoneySense with an explanation.

Financial Author Larry Swedroe recommends the “5/25 rule”, which says you only need to rebalance when an asset class is off by an absolute 5%, or a relative 25%.

Following this rule, if your target bond allocation is 40%, you would rebalance anytime it was off by an absolute 5% – that is, above 45%, or below 35%. For asset classes with smaller targets, the relative 25% figure is more useful. If you’ve allocated 10% to emerging markets, you’d balance any time this fund dipped below 7.5% or rose above 12.5% (because 2 1/2% is 25% of 10%).

Using this, let’s look at the rebalancing that occurred for the rebalancing done poorly and the rebalancing done well. All eyes should be on the Current Allocation column. First, rebalancing done poorly.

And now the rebalancing done well.

The change from the initial allocation and current allocation in the first spreadsheet is only 2.36% while it’s 8.63% for the second one. Therefore, a 2.36% change does not meet the rebalancing criteria of the 5/25 rule while 8.63% does.

Now, here’s the reason why I say the 5/25 rule should only be used as a rule of thumb. If we applied it literally without exception, the portfolio would gave been rebalanced automatically when the allocation changed by 5%. We therefore would not have had the opportunity to rebalance the additional 3.63% (the difference between 5% and 8.63%) and some profiting would have been lost. As such, judgement is required based on what market circumstances are at that time. The 5/25 rule is a good trigger point but not a final decision maker when it comes to rebalancing. Intuition does play a part when it comes to optimal rebalancing. There’s no way around it. For those who lack intuition (no offense intended – some just don’t have it and they are aware they don’t), the 5/25 rule is a perfect mathematical trigger to rebalance.

Cashflow rebalancing

This is just a fancy way of saying, when you have cash available, invest it. 

An example of this would be the wages you receive. For each pay period, a portion of your pay is invested (dollar cost averaging). Another example is that you come across a large sum of funds. Maybe an inheritance, a gift, or a work pension balance invested into a LIRA like I received in 2022. Lastly, it could also be from dividends or interest received from within your investment portfolio throughout the year and then you reinvest it back in. 

In the cashflow rebalancing, it should be done once the cash is available to invest. The 5/25 rule does not apply to cashflow rebalancing. Hesitation is for the weak. Hesitation is a recipe for disaster when you’re sitting in cash and you miss a great opportunity to profit on. 

Rebalancing stocks

I’m going to be brief with this one and say, unless you have a 7 figure investment portfolio, don’t do this. Not for your whole portfolio, at least. First, ETFs are the most efficient way to invest in a balanced and diversified manner. Second, stocks can go to zero and leave you with an empty pocket. It’s a lot harder for an index ETF to do that. Yes, I have a couple stocks in my B&D and there’s a very specific reason I currently hold them and it isn’t to gamble. They also account for a small portion of my overall portfolio. I will discuss all that in a future blog post. 

In conclusIon

My hips don’t lie (sometimes it’s good to channel a little Shakira), this was a long blog post. It is a very important one though. This is what I’ve found most people I’ve met stress over the most. They wonder when they should buy. When they should sell. And when they should rebalance. You could go ahead and rebalance simply using cashflow rebalancing and you’d probably do ok. It’s just that ok isn’t good enough for me when it comes to the health of my financial wellbeing. Or yours. It should be extraordinary. 

So, what do you think? Was rebalancing done poorly versus rebalancing done well an eye opener? How do you feel about the 5/25 rule? Let me know your thoughts.

2 thoughts on “Balance And Diversification – Part 2”

  1. Hi Peter,
    Thank you for this very informative post. My question is sort of related to rebalancing but none of your examples above apply. My husband transferred a LIRA from a former employer to a self-directed account several months before this most recent downturn and consequently he purchased all his ETFs at what looks like a recent peak (and we won’t be adding any future funding). Now his entire LIRA is down 11.5% – it is B&D but all of the ETFs are in the red, some worse than others. If he were to rebalance he would have to sell something at a loss to buy something at an even greater loss – no gainers so far. Have you ever had to deal with a similar situation? You would probably suggest that he ride it out as the new LIRA is in its infancy with, I’m sure, more upturns/downturns to come but I’d still like to hear your thoughts. Thanks, Susan

    1. Hi Susan. Thanks for posting and for the feedback. Much appreciated.

      I empathize with your husband. It’s never fun to be in the red when it comes to hard earned money. I received the lump-sum for my own defined benefit pension back at the beginning of May 2022. I immediately bought ETFs so that I could realign my B&D portfolio to its target allocations. Even though as of today my LIRA is sitting at -4.62%, I have no regrets. When I have cash to deploy, I deploy it and that has served me well so far. I value receiving the dividend and interest payments from that deployment of funds as soon as possible. When it comes to my overall portfolio including the LIRA, TFSA, RRSP, and non-registered account, I’m currently at -10.81% YTD as I write this. That still leaves me in the #2 position against my comparable portfolios.

      In regards to your husband’s LIRA, I’m not sure whether he just has the LIRA or other investments vehicles (TFSA, RRSP, non-registered portfolio, etc.) as well. If his funds including the LIRA were all aligned to their target allocations for his B&D portfolio, and it’s now shifted more than the 5/25 rule, it may be worthwhile to rebalance. If less than the 5/25 rule, then probably not.

      One last thing I’ll add and which will be part of an upcoming blog post shortly, MY PORTFOLIO ASSET ALLOCATION – PART 3 (ZPR), I talk about how all my investment vehicles hold a fixed income component. Even my TFSA has a 15% weighing of fixed income. I understand everyone wants to put just growth stuff into the TFSA however what has worked well for me is the ability to rebalance safe(r) stuff to growth(y) stuff everywhere.

      I hope that helps.

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