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THE IMPORTANCE OF REBALANCING, JANUARY
1996–DECEMBER 2009
During This period, an annually rebalanced portfolio
provided Lower Volatility and Higher return
Average
Annual
Return
Risk
*
(Volatility)
60% Russell 3000/40% Barclays
Aggregate Bond: Annually
Rebalanced
†
10.07
11.84
60% Russell 3000/40% Barclays
Aggregate Bond: Never Rebalanced
†
8.76
13.12
What kind of alchemy permitted the investor who
followed a rebalancing strategy at the end of each year to
increase her rate of return? Think back to what was
happening to the stock market over this period. By late 1999,
the stock market had experienced an unprecedented bubble
and equity values soared. The investor who rebalanced had no
idea that the top of the market was near, but she did see that
the equity portion of the portfolio had soared far above her
60 percent target. Thus, she sold enough equities (and bought
enough bonds) to restore the original mix. Then, in late 2002,
at just about the bottom of the bear market for stocks (and
after a strong positive market for bonds), she found that the
equity share was well below 60 percent and the bond share
was well above 40 percent, and she rebalanced into stocks.
Again, at the end of 2008, when stocks had plummeted and
bonds had risen, she sold bonds and bought stocks. We all
wish that we had a little genie who could reliably tell us to
“buy low and sell high.” Systematic rebalancing is the closest
analogue we have.
5. Distinguishing between Your
Attitude toward and Your Capacity
for Risk
As I mentioned at the beginning of this chapter, the kinds
of investments that are appropriate for you depend
significantly on your noninvestment sources of income. Your
earning ability outside your investments, and thus your
capacity for risk, is usually related to your age. Three
illustrations will help you understand this concept.
Mildred G. is a recently widowed sixty-four-year-old. She
has been forced to give up her job as a registered nurse
because of increasingly severe arthritis. Her modest house in
Homewood, Illinois, is still mortgaged. Although the mortgage
was taken out at a relatively low rate, it involves substantial
monthly payments. Apart from monthly Social Security
checks, all Mildred has to live on are the earnings on a
$250,000 insurance policy of which she is the beneficiary and
a $50,000 portfolio of small-growth stocks accumulated by
her late husband.
It is clear that Mildred’s capacity to bear risk is severely
constrained by her financial situation. She has neither the life
expectancy nor the physical ability to earn income outside
her portfolio. Moreover, she has substantial fixed
expenditures on her mortgage. She would have no ability to
recoup a loss on her portfolio. She needs a portfolio of safe
investments that can generate substantial income. Bonds and
high-dividend-paying stocks, as from an index fund of real
estate investment trusts, are the kinds of investments that are
suitable. Risky (often non-dividend-paying) stocks of small-
growth companies—no matter how attractive their prices
may be—do not belong in Mildred’s portfolio.
Tiffany B. is an ambitious, single twenty-six-year-old who
recently completed an MBA at Stanford’s Graduate School
of Business and has entered a training program at the Bank of
America. She just inherited a $50,000 legacy from her
grandmother’s estate. Her goal is to build a sizable portfolio
that in later years could finance the purchase of a home and
be available as a retirement nest egg.
For Tiffany, one can safely recommend an aggressive
portfolio. She has both the life expectancy and the earning
power to maintain her standard of living in the face of any
financial loss. Although her personality will determine the
precise amount of risk exposure she is willing to undertake, it
is clear that Tiffany’s portfolio belongs toward the far end of
the risk-reward spectrum. Mildred’s portfolio of small-
growth stocks would be far more appropriate for Tiffany
than for a sixty-four-year-old widow who is unable to work.
In the ninth edition of this book, I presented the case of
Carl P., a forty-three-year-old foreman at a General Motors
production plant in Pontiac, Michigan, who made over
$70,000 per year. His wife, Joan, had a $12,500 annual
income from selling Avon products. The Ps had four children,
ages six to fifteen. Carl and Joan wanted all the children to
attend college. They realized that private colleges were
probably beyond their means but hoped that an education
within the excellent Michigan state university system would
be feasible. Fortunately, Carl had been saving regularly
through the GM payroll savings plan but had chosen the
option of purchasing GM stock under the plan. He had
accumulated GM stock worth $219,000. He had no other
assets but did have substantial equity in a modest house with
only a small mortgage remaining to be paid off.
I suggested that Carl and Joan had a highly problematic
portfolio. Both their income and their investments were tied
up in GM. A negative development that caused a sharp loss
in GM’s common stock could ruin both the value of the
portfolio and Carl’s livelihood. Indeed, the story ended badly.
General Motors declared bankruptcy in 2009. Carl lost his
job as well as his investment portfolio. And this is not an
isolated example. Remember the sad lesson learned by many
Enron employees who lost not only their jobs but all their
savings in Enron stock when the company went under. Never
take on the same risks in your portfolio that attach to your
major source of income.
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