Discipline, Temptation, and Asset Allocation

[Maurice]

This is a question to the passive investors - those who decide on an asset allocation model, implement it, and then ignore it except for annual or bi-annual rebalancing. (I assume there are plenty of you out there given the number of times I've seen Bernstein's books recommended)

Do you ever catch yourself wanting to time the market? Do you give in to your temptations?

I usually don't, in fact I never had, but I did this week. I hold FXI - the iShares ETF that is a reasonable proxy for China. It has just about doubled this year (and quadrupled since I bought it in Jan-2005). I'm a bit worried that China is in a bubble (although I'm still a long-term China bull) so I sold half of my position - nothing too drastic, since it has doubled it was essentially the rebalancing I would have done in the new year anyway.

Its the first time I've transacted outside of my annual rebalancing since I adopted this investing approach 5 years ago or so.

 

[REWahoo]

I think all of us fall off the wagon occasionally. I've managed to keep my urges in check by selling/buying only a small portion of my portfolio if I just have to scratch that timing itch. So far it seems to be working for me...

 

[kumquat]

I have a huge position in one stock (~40% of NW). Every so often I can't stand it and sell 20%. A few month later it's as big a portion of my NW as it was when I sold. A true AA'r would sell 90% tommorrow. Other than this one, I'm fairly disiplined.

 

[RetireeRobert]

I usually don't, in fact I never had, but I did this week. I hold FXI - the iShares ETF that is a reasonable proxy for China. It has just about doubled this year (and quadrupled since I bought it in Jan-2005). I'm a bit worried that China is in a bubble (although I'm still a long-term China bull) so I sold half of my position - nothing too drastic, since it has doubled it was essentially the rebalancing I would have done in the new year anyway.

Its the first time I've transacted outside of my annual rebalancing since I adopted this investing approach 5 years ago or so.

You got within 3 or 4 months of the new year when you would have rebalanced anyway, and then sold off half the China ETF. I don't think that is really "falling off the wagon", or becoming a "timing" trader.

You could as well think a rebalancing rule could be:
either (1) when a sector/position at least doubles (or is up 50%, etc),
or (2) annually. Whichever comes first.

IMHO, that is not an unreasonable way of formulating a rebalancing rule. And I don't think formulating it this way would lead to very much more frequent rebalancing, or increase the attendent transaction costs. Phrasing the rebalancing rule this way still curbs the frequent emotional trading. But also recognizes the valid concerns that arise with sharp runups/downs of one sector/position or another.

 

[Dawg52]

I'm pretty much a passive investor but to satisfy the urge to time the market, I actively manage 10% of my portfolio.

 

[Nords]

Do you ever catch yourself wanting to time the market? Do you give in to your temptations?

My grandfather left me a few thousand $$ inheritance, so I set up a "brilliant investor" account at Fidelity with options & margin. I spent about five years learning what the heck I was doing, lost some money, made some money, and got tired of it. I moved the remaining individual-stock positions to our ER portfolio and we'll gradually liquidate them for expenses.

The rewards from active investing are no greater than the effort one puts into active investing, and sometimes they're a good bit less. It's actual real work. I think Bernstein says that eventually you decide you'd rather have a life. Or maybe it was Swedroe.

 

[Moemg]

I used to panic and sell when things were dropping .Bad move ! Now I just passively invest and rebalance as needed.

 

[audreyh1]

The beauty of AA is that you take advantage of market swings. Like many people, I don't use a fixed time frame on rebalancing the portfolio, but rather add to an asset class when it gets beaten down, and trim an asset class after a large run. I monitor the deviation of my bonds/stocks to my ideal allocation, and adjust when they get out of whack. Same with international versus domestic, and large versus small. I only take actions once or twice a year. There has to be a major market move OR a longish time frame for my portfolio to become sufficiently out of balance to take action.

I DO NOT sell an asset class anticipating a downturn, or add to an asset class anticipating a run up. I notice lots of folks or various investing forums who seem to be unable to resist taking anticipatory action - human nature, I guess. I've learned too many times that I am usually wrong. Instead, I take action after the downturn or run up has already occurred (if it does).

So, no, I don't "stray". The nice thing about AA is that you don't have to guess what the market is going to do, you just have to react.

Audrey

 

[Alan]

Do you ever catch yourself wanting to time the market? Do you give in to your temptations?

Whenever I feel tempted I remember an interview I heard on the radio with a big pension fund manager. The interviewer reminded him that he was selling huge amounts of stocks and buying bonds with the proceeds a few weeks before the big market drop a few years back (2001?) and then he sold massive amounts of bonds and bought stocks just before bonds went flat and stocks took off 2 or 3 years later. How did he time it so well?

His response was that he did not nothing clever but simply followed the pension fund rules governing its AA. In each case the asset class had gone out of balance by 5%, so he re-adjusted.

So, I don't re-balance more than once a year unless I get to 5% out of balance which rarely happens. If the big boys can discipline themselves by setting rules and sticking to them, then so can I

 

[CybrMike]

I fell off the wagon a couple days ago and moved from a 2% emerging markets AA to a 10%. I sold off some mid-cap US stocks. I also upped my europe and Australia/Asia/Japan (EFA & FEZ) ETFs to total 32%. It had been about 20% before. So total international (including emerging mkts) is now 42% of my portfolio.

I'm a few years late but I don't see the dollar getting any better unless Ron Paul gets elected. I'd rather own businesses paying me in currency that isn't dropping like a rock.

If things fundamentally change and the govt stops spending like a drunken sailor, I might adjust some back to US positions.

 

[youbet]

I take action after the downturn or run up has already occurred (if it does).

Audrey

How do you decide when a run up has concluded? Do you ever find that you sold when the run up was only half over? Or do you ever wait because you feel the run up will continue, but instead the equity rapidly loses value?

 

[Maurice]

I DO NOT sell an asset class anticipating a downturn, or add to an asset class anticipating a run up. I notice lots of folks or various investing forums who seem to be unable to resist taking anticipatory action - human nature, I guess. I've learned too many times that I am usually wrong. Instead, I take action after the downturn or run up has already occurred (if it does).

That's a good point - there's a big difference between 'straying' by reacting to a big movement in the market and 'straying' by thinking you can see into the future.

So, I don't re-balance more than once a year unless I get to 5% out of balance which rarely happens.

Thats not a bad concept, but 5% seems very low. (I assume that's 5% off the target position not 5% of the portfolio.)

 

[Maurice]

How do you decide when a run up has concluded? Do you ever find that you sold when the run up was only half over? Or do you ever wait because you feel the run up will continue, but instead the equity rapidly loses value?

I know this wasn't directed at me, but in my case I'd say we don't know that a run up has concluded but we do know when one has occurred. If I go back to my FXI example, I had already sold a bunch in early 07 after last year's run up, so in that sense I left a bunch of money on the table.

If you think about it, rule-based rebalancing is an attempt at market timing - its forcing you to buy low and sell high over time. And while its highly imperfect its better than most of us would do on our own.

 

[Maurice]

The beauty of AA is that you take advantage of market swings. Like many people, I don't use a fixed time frame on rebalancing the portfolio, but rather add to an asset class when it gets beaten down, and trim an asset class after a large run. I monitor the deviation of my bonds/stocks to my ideal allocation, and adjust when they get out of whack. Same with international versus domestic, and large versus small. I only take actions once or twice a year. There has to be a major market move OR a longish time frame for my portfolio to become sufficiently out of balance to take action.

Is your method rule-based (e.g. x %) or more based on gut-feel? I think some sort of mid-year adjustment rule makes sense, indeed I essentially implemented one this week with FXI. But my ad-hoc 100% rule seems rather drastic - especially for an index investor.

I assume this is the kind of year where you would have made mid-year corrections - what with EM, China, AsiaPac (ex-Japan) going crazy, a big fall in the dollar, and the (relatively) poor performance of small cap.

 

[audreyh1]

How do you decide when a run up has concluded? Do you ever find that you sold when the run up was only half over? Or do you ever wait because you feel the run up will continue, but instead the equity rapidly loses value?

I don't know that the run up has concluded. All I know is that an asset class has moved X% out of range with respect to the other asset classes, so I trim it back to it's original allocation. If it moves up X% again, I trim again.

This happened with REITs in 2003, 2004, 2005, 2006, early 2007. I know lots of people who blew out of REITs in 2005 convinced that a crash was imminent.

BTW - now it's time to add to REITs.

You don't have to "think". You just monitor your asset class balances.

It's important to point out that I limit my actions to once or twice a year, preferably even longer. You've got to give divergences time to happen.

Audrey

 

[audreyh1]

That's a good point - there's a big difference between 'straying' by reacting to a big movement in the market and 'straying' by thinking you can see into the future.

Nitpick (not really), but rebalancing your portfolio after a big movement in the market is not 'straying'. It's the whole point of AA!!!

Audrey

 

[ziggy29]

I understand your concerns. I've been an asset allocator since late 2000 -- it saved my butt big in 2001 and 2002; while the S&P was down about 35% in those two years and the Nasdaq much worse than that, I was off only about 7.5% in the two years combined. Small caps, REITs, emerging markets and gold stocks way outperformed, which almost offset the loss I took in large caps.

This year is the first year I'm lagging the S&P since I started (by about 1.5%). There are temptations for me to take some off the table because I don't like what I see with respect to the dollar, the housing market and oil prices. But I also know that I've outperformed over the last seven years largely because I've taken emotion out of the equation and stuck to a mechanical discipline. So I'm trying to resist the temptation, but it isn't easy.

Moving money out of "hot" asset classes is what asset allocation is all about -- but it should be done with a mechanical strategy, IMO -- either once every X months (where X is about 12 to 18 ) or whenever you have an asset class more than X% "out of whack" with your target allocation.

 

[Nords]

BTW - now it's time to add to REITs.

Did I miss a flashing blue light? Or did I just miss the sarcasm?

What's the logic behind investing in REITs now?

 

[audreyh1]

No sarcasm. I'm sure I'll be adding before too long - whenever I do my next rebalance.

The AA logic? - The sector has been walloped. So it is now underweight compared to the rest of my portfolio. When sectors get walloped, you buy some more. Even if you think they might stay walloped for a while or even get worse. That's the rules!

Audrey

 

[ziggy29]

No sarcasm. I'm sure I'll be adding before too long - whenever I do my next rebalance.

The AA logic? - The sector has been walloped. So it is now underweight compared to the rest of my portfolio. When sectors get walloped, you buy some more. Even if you think they might stay walloped for a while or even get worse. That's the rules!

Looking at my AA spreadsheet, I started the year with 8.72% of my portfolio in REITs and it's now down to 7.65% (my target allocation is 9%).

On the other hand, I started with 6.17% in emerging markets (EEM) which is now 8.00% (target allocation is 6%).

My spreadsheet tells me that if I were to rebalance today (which I'm not), I'd need to sell about $4,900 of EEM and buy about $3,300 in REITs. It may be true that REITs have farther to go down still, but the way AA works, when it's their turn to shine again, we'll own a lot more of it. And when emerging markets start to melt down as they occasionally do, we'll own less of it.

Also, since REITs have outperformed for several years before this one, by rebalancing we're taking a hit on fewer shares than if we didn't rebalance.

 

[WM]

I can honestly say I've never once bought or sold anything in response to what the markets are doing, in my whole 5-year career as a serious investor

I don't invest in REITs because we already own a house in San Diego that's had a huge run-up in value (thankfully it wasn't in a fire zone) and its equity is dominating our portfolio (it's a rental, not our primary residence).

I'm also not in bonds, because we're young and we're planning on DH's military pension to kick in, which I'm counting as future bonds. However, I will probably start putting some money into bonds (I will start getting a salary soon) because I believe in the research that says up to 20% bonds will add stability and not substantially decrease performance.

Aside from some cash, that leaves US and foreign stock. And of those I guess I feel my allocations are very rough, and it would be hard to get very far outside the ballpark range of what seems ok. Perhaps this is too cavalier. At this point, we are still very much in savings mode, so when I do my once-per-year check and I want to raise an allocation, I shift our monthly savings transfers accordingly.

 

[DblDoc]

That's a good point - there's a big difference between 'straying' by reacting to a big movement in the market and 'straying' by thinking you can see into the future.



Thats not a bad concept, but 5% seems very low. (I assume that's 5% off the target position not 5% of the portfolio.)

The "rule" I have seen is 5% of your portfolio for assets which are a significant part of your portfolio - say 20% of the total. So you would rebalance once outside 15 or 25%. For small assets you rebalance when it is off by 25% of the target allocation, so for something that is targeted at 5% then rebalance when outside 3.75% (5% - 5*0.25) or 6.25% (5% + 5*0.25). Personally I use the latter only as my portfolio is sliced and diced to the point that no one asset is bigger then about 10% of my total.

As I'm accumulating I don't sell anything, just add to the lagards. This summer was a good learning experience for me in this passive approach. After much research (stealing ideas from here and elsewhere ) I set my AA. I was way too low on total international, ISC, IV. Many pundits were saying these asset classes were way overpriced, had had their run would wait etc. I took the plunge anyways (reciting the mantra over and over again). Those assets have since been the driving force for the growth of my portfolio...

DD
DD

 

[Alan]

The "rule" I have seen is 5% of your portfolio for assets which are a significant part of your portfolio - say 20% of the total. So you would rebalance once outside 15 or 25%. For small assets you rebalance when it is off by 25% of the target allocation, so for something that is targeted at 5% then rebalance when outside 3.75% (5% - 5*0.25) or 6.25% (5% + 5*0.25). Personally I use the latter only as my portfolio is sliced and diced to the point that no one asset is bigger then about 10% of my total.

for me 5% is by major asset class, stocks/bond/cash.

If I end up with stocks at 35% of the total portfolio I will then re-balance to get back to stocks being 40% of total. I only rebalance between small/mid/large US/International etc once a year

 

[audreyh1]

My bands are even tighter. I subtract the difference between stocks versus bonds/cash from their target allocation. So for me if say stocks go to 62.5% and bonds/cash to 37.5%, that's a 5% difference and enough to trigger rebalance.

That may seem tight, but it usually takes quite a bit of a market move or a long time to trigger such an event, probably somewhat due to the extra little tax-friendly rebalance tweak I make below.

I selectively reinvest distributions. If some of my funds have way outperformed for a given year, I take the distributions in cash. Otherwise I reinvest. This is to minimize the tax ramifications of selling something to rebalance.

Audrey

 

[HFWR]

Truman Clark, of DFA, examined the issue of rebalancing in detail in three papers published online in Fall of 2001. He concluded that, "the proposition that a rebalancing strategy can increase expected return is dubious," and that "rebalancing costs definitely reduce expected returns."

Evanson Asset Management - Asset Allocation Rebalancing and Long-Term Investment Return Information