I hear this question often: Is it possible to boost your returns to beat low-cost index funds?
The answer is, yes, I think you can do that by owning those funds and rebalancing. Let’s examine the logic of this strategy and how it’s worked so far this century.
Though markets may not be predictable, human behavior in response to market movements absolutely is. Markets surge and investors get greedy and buy; markets plunge and investors get fearful and sell. These predictable responses are why many studies show dollar-weighted (investor) returns often lag fund returns. Carl Richards appropriately calls this the Behavior Gap.
But you can flip the script by systematically taking Warren Buffett’s advice to “be fearful when others are greedy and greedy when others are fearful.”
Rebalance, Rebalance, Rebalance
How can one accomplish this? Rebalance. By rebalancing to a target asset allocation, you have to buy stock funds after a plunge and sell after a surge.
So far in the first 18 years of the century, rebalancing has boosted returns. I looked at simple, three-fund portfolios of the Vanguard Total Stock Index (VTSMX), the Vanguard Total International Stock Index (VGTSX) and the Vanguard Total Bond Index (VBMFX). (The equivalent ETFs are the Vanguard Total Stock Market ETF (VTI), the Vanguard Total International Stock ETF (VXUS) and the Vanguard Total Bond Market ETF (BND), but they haven’t been around that long.)
I compared the returns rebalanced twice a year (on June 30 and Dec. 31) to the buy-and-hold portfolios.
The allocations are as follows:
In all three allocations, the rebalanced portfolio bested the buy-and-hold. The largest differential, however, came in the moderate portfolio, where rebalancing bested buy-and-hold by nearly 18 percentage points over the 18-year period. That’s because the moderate portfolio had to do more buying and selling to get back to target.
For a larger view, please click on the image above.
Yes, this was a period when stocks and bonds had similar performance. Moreover, critics point out that, in the long run, stocks will outperform bonds, and rebalancing takes from returns.
But let’s say stocks do outperform bonds over the next 18 years and, by the end of the period, the 50% stock buy-and-hold portfolio becomes 70% stocks. I argue that the buy-and-hold portfolio would average roughly 60% stocks during the period, and that is what the buy-and-hold portfolio should be compared to. My hypothesis is the rebalanced 60% portfolio will outperform.
The key purpose of rebalancing is to maintain the appropriate level of risk, but it is also likely to increase overall returns. Since I suspect the predictability of human emotion isn’t going to change, rebalancing systematically implements Buffett’s advice of getting greedy when others are fearful, and vice versa. And a moderate portfolio captures more of this excess return than an aggressive portfolio.
When it comes to how often one should rebalance, my advice to clients is to rebalance as often as they want to, but to set a tolerance when they must rebalance. Though there are no guarantees as to which rebalancing method will work best in the future, any systematic rebalancing will likely capture greater returns. I advise taking a tax-efficient approach when rebalancing and using traditional and Roth accounts.
Admittedly, rebalancing is not always an easy thing to do. If you find doing it yourself is daunting, consider a low-cost target-date retirement fund that will do it for you on auto-pilot.
Allan Roth is the founder of Wealth Logic LLC, an hourly based financial planning firm. He is required by law to note that his columns are not meant as specific investment advice. Roth also writes for the Wall Street Journal, AARP and Financial Planning magazine. You can reach him at [email protected] or follow him on Twitter at Allan Roth (@Dull_Investing) · Twitter.