Gulp! Asset Allocation & Rebalancing Theory Meet a Scary Real World

Have you set up your portfolio structure according to a defined asset allocation with explicit rebalancing rules, as many experts suggest and as we advocate in this blog? Are you coming up to an annual review date to rebalance holdings in the new year after the 2011 results are in? Or perhaps the percentages allocated to each asset class have gone beyond the limits set to trigger rebalancing.

If you have noticed the large performance divergence of various asset classes this year, then the difficult reality of current economic and market conditions will surely test your resolve to go ahead with rebalancing.

Example portfolio - Complete Couch Potato
Let's take one of the model portfolios composed of common ETFs - the Complete Couch Potato - from the popular Canadian Couch Potato blog to illustrate the kind of anxiety-laden situations facing the investor trying to practise disciplined portfolio management. CCP also publishes up-to-date performance figures for the various portfolios and its ETF components, which is very handy since the value of distributions and the effect of currency swings on the US-denominated ETFs is taken into account. Below is a table of the portfolio and how it has performed since the start of the year.


Psychological barriers to rebalancing
The arithmetic about how to rebalance by buying some ETFs and selling others, as shown in the performance table above, is not the issue. The challenge is actually convincing yourself that it makes sense. Consider the situation:

• Canadian Equity - The TSX has been in a downward trend for months now. It doesn't look as though things are likely to get much better anytime soon. The temptation is to wait.
• US Equity - Thanks to the fall of the Canadian dollar against that of the USA along with the receipt of dividends, VTI has managed a slight gain. One might be tempted to put more money into VTI since it looks as though the economic situation in the USA may be stabilizing but our rebalancing calculation tells us to do nothing.
• International Equity - Here is the scariest situation. Our policy says to buy more VXUS when all it has done during the year is slide downwards to a 10% loss. Not only that, the underlying problems in Europe could well get a lot worse, Japan still struggles and now China is said to be slowing down. Poor decisions by authorities might lead to disaster, or perhaps we are already inevitably heading that way. The urge to hold off buying, if not to sell and run for safety, is understandably strong.
• Real Estate, Real Return Bonds and Canadian Bonds - These have been the bright spots, providing the biggest positive returns that have enabled the overall portfolio to eke out a small gain for the year. Rebalancing tells us to sell some of each yet it is hard not to consider that the underlying conditions that produced such returns seem still to be in place. Why not stick with the winners which, after all, are the safest of the holdings in these dangerous times?

Such is the dilemma facing the investor trying to follow the standard advice about diversification, asset allocation and rebalancing. It is much easier to rebalance when everything is going up and it is only a reallocation from a big winner to a small winner. Taking from winners to give to the losers is much tougher. Who knows it might not even be the correct choice.

Long term faith in outcomes is required
The dilemma today highlights that the main challenge we face as investors is ourselves in following our plans despite doubts and uncertainties. Should we adopt the same blind faith as one of the most successful investors ever, Warren Buffett, who said this?

"In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497" (source BrainyQuote)

Was the original portfolio allocation appropriate?

A reluctance to rebalance also raises the question of whether the original allocation percentages were appropriate for our individual circumstances. Is the 50% allocation to stocks necessary or reasonable if our savings goals have been reached? Is our time horizon for staying invested and not spending the money allocated to equity at least ten years, since that amount of time could easily be required before stocks again begin to pull ahead of bonds? The credit crisis and debt deleveraging troubles are very severe so it should not be a surprise that recovery takes a long time.

Diversification has worked again
The other thing to remind ourselves is that the diversified portfolio has produced a small but positive gain overall (2.2% in this case). That should help encourage us to continue following the basic strategy predicated on the idea that different asset classes will perform differently from year to year but will usually produce positive returns.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.