Is Portfolio Rebalancing being overplayed?

[Matt]

I recently built a simple rebalancing tool and in doing so discovered how implementing a manual rebalancing strategy is very straight forward. I enjoy building things from scratch as it forces me to really think about what is going on with the concept at hand, and explore its underlying value. Time to share some of my thoughts on this now.

Portfolio rebalancing means that you buy more of an underperforming asset within your allocation in order to return your mix to a predefined level. It counters something called Portfolio Drift. I outlined previously that there are two main ways to rebalance: Sell and Buy, or Buy More. The former can have tax implications when deployed purely within taxable accounts. For more reading on the two approaches see the post Two good ways, and one really bad way to rebalance your portfolio.

But what is rebalancing really, and why are we doing it?

At its heart, rebalancing is risk management. It starts out with your investment policy statement, and defining your asset allocation. If you decide that you are comfortable with 80/20 stocks to bonds you can project the savings amount required to get you to financial independence. In bull markets stocks will outperform, and when they do you become more heavily weighted in stocks to bonds, meaning that you are more 'at risk' of a movement backwards.

Does rebalancing increase returns?

If you look at the marketing material for Robo-Investments you will see they claim that automatic rebalancing adds a 0.4% upside to your portfolio. Both Betterment and Wealthfront simply cite the same page from the same book for the proof here: Swensen, David, Unconventional Success, 2005, pp. 195-96.

However, the reality is that for the past 5 years we have been in a bull market, and as such rebalancing has reduced returns, as you are constantly reducing your position in an asset that has continued to appreciate. The value of the rebalanced portfolio is not in upside in such times, it is in downside protection. As such, I wonder if automatic portfolio rebalancing is being overplayed to its customer base, and if people actually realize they are losing out in these markets.

Age and income matter a lot when it comes to rebalancing. As you near retirement age, and rely increasingly on your own assets to inherently protect themselves from volatility using the Repair Ratio concept, rebalancing gains in value, but for younger, more aggressive investors, one wonders if a little drift may not be a bad thing. My take on it is that rebalancing is an essential tool for asset allocation, and every portfolio should consider it, I just wonder whether it should be automatically included.

What do you think about automatic rebalancing, are you aware that it has been reducing your returns in recent years, or do you think that the marketing from people promoting it is accurate and your returns really are increasing by 0.4%?

Edit - for further reading, and for those who think my point reflecting a 5 year bull market was too narrow and selective, please see this white paper by Vanguard, the figure below is from page 7.

 

[Mountain Trader]

Great post, Matt and I hope members will take the time to read it.

We've re-balanced to a point over the last 5 years. This has been very tough to swallow, since it meant selling equities which were skyrocketing and buying fixed income (or staying in cash) which was and is paying almost nothing. We did so because re-balancing is based our objectives as to income, risk and available funds, and is an admission that we don't know which way the markets will go tomorrow. Psychologically, it is very hard to do this in either good or bad markets since you will always be selling recent winners and buying recent losers.

When I saw the thread title, I thought at first you might be writing on using up United miles and acquiring more Delta miles. Now that would be re-balancing that is really hard to swallow (but maybe not as completely crazy as it seems).

 

[Ryan-o]

Does this suggest the frequency of rebalancing is correlated to your age/risk? The closer you are to retirement, the more frequently you should rebalance? I know most people suggest 1x per year but I have also read evidence that quarterly rebalancing is more effective. Thoughts?

 

[cocobird]

I am retired and I rarely rebalance. I believe that there are many factors involved in the decision. For instance, I have sufficient liquidity, which serves me well no matter what the stock market or other riskier strategies are doing. In addition, I have a defined benefit program, which provides an adequate pension for my household's living expense. So I can afford to take more risks than many and I do. My portfolio looks more someone who in their late 20s or 30s so that I have benefited from the bull market. This makes sense for someone like me who was a financial professional and adopted a range of conservative and risky strategies. In that sense I am and continually stay balanced overall.

I believe that one of the primary points of Matt's post is whether people are cognizant that in a bull market, there can be a lost opportunity cost in a bull market.

The tradeoff in volatility versus opportunity cost is an issue that plagues people, especially with the trend toward forcing them to handle their retirement plans using defined contributions. The majority of people do not have sufficient training or understanding of financial vehicles to effectively manage their investments. In that sense automated savings and rebalancing may be a saving grace. The alternative, as we saw in the severe 2008 downturn, were people who panicked and pulled their money out of the market into so called safe investments such as bonds, CDs, savings, or money market accounts. As a result, when the following bull market occurred, many people did not fully recover from the downturn when they ran from the stock market. That too is a huge lost opportunity. So the question is which was the greater evil - lost opportunity when you handle your finances yourself or lost opportunity when finances are automated. If those same people had been in an automated system, they would not have lost as much as they did. The purpose of an automated system is to enforce discipline and to smooth out the bumps so that the lows are now as low and conversely the highs are not as highs.

My thought is that it depends on the skill and knowledge of the individual. For most people, an automated system would be more effective if it forced people to save a certain percentage of income and invested it for them because that would save them from their fears, their inexperience, and their own greed. Mayhaps some think I overreach with that statement, but I would argue how else do scams continue to flourish over the years (example - the Nigerian money scam, the Madoff debacle, etc.).

Yes I believe there is no such thing as a free lunch. This is equivalent to physics that there is an equal and opposite reaction.

What people do not seem to recognize is who is paying for that free lunch. For everyone who lost money, someone made money. Or reverse that if you like and for everyone that made money, someone else lost. Although in the current economy, it isn't a one to one situation. For each big winner, there are probably thousands or maybe millions of small losers.

 

[Matt]

Does this suggest the frequency of rebalancing is correlated to your age/risk? The closer you are to retirement, the more frequently you should rebalance? I know most people suggest 1x per year but I have also read evidence that quarterly rebalancing is more effective. Thoughts?

You shouldn't rebalance by date, but by drift. You should check in as much or as little as you wish, I prefer as little. But you could go a decade without a rebalance if the market doesn't move out of your tolerance parameters.

 

[Alex1432]

It is being over sold because drift in the portfolio is just one item in one's financial picture. If you have other sources of income during the bad times and don't have to sell to make ends meet then losing that up side during the bull market is list income.

Unfortunately when it rains it pours chances are higher that in the down turn you may lose your job then you may have no choice but to sell. Then a re balanced portfolio would have protected you against losses.

 

[Sesq]

I am only about 1/2 way through Jim Otar's book (because its on my wife's kindle), but he did studies a while back that came mostly to the same conclusion. He did suggest date rebalancing that was in the range of every 4 years or so. Kind of becomes like dollar cost averaging. The general trend is equities rise, so DCA becomes a loser in general. But, if you dump it in during the exception to the rule, ouch.

I am wholly unscientific in my rebalancing. If I am looking at my portfolio and the thought pops in the head, and the holdings are out of whack, then I might hit the button on the fidelity website. I am probably doing it more than I should, about once a year or two. I am 75/25.

 

[Mountain Trader]

For me, rebalancing should be done when something changes. Market and/or rates go up-run the numbers. Down? Run the numbers. I am talking about meaningful moves like 10-15 percent.

Another change is age, so even if everything else is stable, I run the numbers every two years.

All that sounds great but, like many, I run the numbers but I rarely do a complete rebalancing. If computations indicate I should move 10% from stocks to fixed income, I'll start a multi-month program to do that, but I rarely get the plan completed, as something comes up, markets change or I just get complacent.

 

[Julian Brennan]

Our retirement portfolios are not being rebalanced at all. The reason for this is the stocks (the only asset class in these accounts) are selected purely to generate income in form of dividends. Daily, monthly, quarterly price fluctuations don't matter at all. I'd only sell a stock if fundamentals in the underlying business change, i.e. dividends are frozen or cut or the business model is rendered unsustainable.

The only party making a killing out of rebalancing is the brokers and that's why they keep on preaching this. Why would I sell a winner or buy a loser? Makes no sense. Focus on the business instead of the price and you're all set for the long run. Not buy and hold but rather buy and monitor!

 

[Matt]

Our retirement portfolios are not being rebalanced at all. The reason for this is the stocks (the only asset class in these accounts) are selected purely to generate income in form of dividends. Daily, monthly, quarterly price fluctuations don't matter at all. I'd only sell a stock if fundamentals in the underlying business change, i.e. dividends are frozen or cut or the business model is rendered unsustainable.

The only party making a killing out of rebalancing is the brokers and that's why they keep on preaching this. Why would I sell a winner or buy a loser? Makes no sense. Focus on the business instead of the price and you're all set for the long run. Not buy and hold but rather buy and monitor!

The problem I see with that is the average investor doesn't have access to the proper data, nor the time required to make complete decisions in this manner - I do think it is the proper way to invest, but I don't know how viable it is.

 

[Mountain Trader]

Our retirement portfolios are not being rebalanced at all. The reason for this is the stocks (the only asset class in these accounts) are selected purely to generate income in form of dividends. Daily, monthly, quarterly price fluctuations don't matter at all. I'd only sell a stock if fundamentals in the underlying business change, i.e. dividends are frozen or cut or the business model is rendered unsustainable.

The only party making a killing out of rebalancing is the brokers and that's why they keep on preaching this. Why would I sell a winner or buy a loser? Makes no sense. Focus on the business instead of the price and you're all set for the long run. Not buy and hold but rather buy and monitor!

I think I agree with yor first paragraph since your pool of dividend paying stocks defies rebalancing, unless your sub-categorize within that group.

I disagree with your second paragraph. The principal of balancing is based on an allocation among asset classes, which allocation changes over time. If instead the focus is on stock picking, then you buy and sell based on that. These are two different approaches, neither being wrong or right per se, but either can be wrong if used in the wrong instance.

My experience is that self-interest focused brokers often do not care for folks who use a portfolio balancing approach since they don't buy or sell much. However many love stock pickers for exactly the opposite reason.

 

[Julian Brennan]

Matt: it's actually quite easy with the right tools. I'd bet you know what the CCC list is? If not you might want to have a look at seekingalpha.com author David Fish. I'd also dare to say that "having not enough time for this" is a pretty lame excuse. It's planning ahead for the retirement which nowadays can amount to the same timeframe of anyone's life span as their working life. One could as well argue that you have no time for school which prepares you for that working life.

MT: of course we can all have our own opinions and nobody says they're right or wrong - it's just an opinion. What works for me doesn't necessarily have to work for you or the next guy. The whole rebalancing is based on the assumption that you coinstantly have to buy low and sell high and this is a) what I don't do and b) what makes the brokers rich. You probably heard of the book "Where are the customers' yachts?"
I just decided to focus on income and hence no selling under normal circumstances and no rebalancing required because there's only one asset class.

 

[Alex1432]

Julian aren't you rebalancing your portfolio by adding and removing stocks whose dividend payout may have changed? If you own stock x and it paid ten percent dividend but tomorrow the company announced its cutting the dividend to one percent don't you have to remove it from your portfolio?

Everyone has things they enjoy doing and things they have to do. I don't enjoy doing portfolio management but I have to so I try to minimize what I have to do. If you enjoy reading reports and looking at graphs more power to you and your portfolio may do better then mine.

 

[El Ingeniero]

I am firmly in the camp of rule/model/checklist based investing for the masses, and even for professionals, with the caveat that reversion to mean can have an upside as well as a downside. We can count on one hand the number of investment professionals that beat their benchmark for over 20 years, and if we look at what they do, then we see that they are basically blindly following some rules.

 

[Julian Brennan]

Alex, of course I constantly add or increase positions to my portfolio since I'm still in the accumulation phase but I wouldn't call this rebalancing. Rebalancing in a classic sense is the reallocation of different asset classes to their targeted values. Since I only have one AC there's no targeted value, i.e. the AC "equities" has a target value of 100% and will always have that.

If there's a certain equity which I decide no longer offers me the benefit which I added it for, I wouldn't call this rebalancing as well. It's simply a shift from one stock to another. And of course I try to avoid this by selecting my holdings very carefully. You can't always be right but IMO the odds are much better. And you save a ton of fees along the way.

 

[El Ingeniero]

However, the reality is that for the past 5 years we have been in a bull market, and as such rebalancing has reduced returns, as you are constantly reducing your position in an asset that has continued to appreciate. The value of the rebalanced portfolio is not in upside in such times, it is in downside protection. As such, I wonder if automatic portfolio rebalancing is being overplayed to its customer base, and if people actually realize they are losing out in these markets.

Problem is that no one knows when the bull market ends. We can make rules for that, but of course they aren't perfect. But I would argue that being in cash 70% of the worst down days of a bear market pays off better than buy and hold.

 

[Matt]

having not enough time for this" is a pretty lame excuse. It's planning ahead for the retirement which nowadays can amount to the same timeframe of anyone's life span as their working life. One could as well argue that you have no time for school which prepares you for that working life.

I spend plenty of time planning for retirement, I just don't believe stock picking offers the alpha you seek.

If the amount of upside was worth it, why work rather than do this full time?

If you can make an additional $40k per year stock picking (over indexing with skews) then you should be 'retired' already. If you can't then IMO I'd rather earn more money from side gigs and set up investment property.

Stock picking can be a hobby for the Financially Independent (with play money) but strikes me as a waste of time for other people.

It can be a fun waste of time, and there are worse, but it doesn't show me the ROI that my time needs.

 

[Matt]

Problem is that no one knows when the bull market ends. We can make rules for that, but of course they aren't perfect. But I would argue that being in cash 70% of the worst down days of a bear market pays off better than buy and hold.

Absolutely. My original purpose for the thread was to show how rebalancing fails to perform. I think it's noteworthy when all these robo brokers claim alpha, but their actual performance is below the market, and has been since inception.

 

[Hanaleiradio]

"The trend is your friend."
"Ride the winners and cut the losers."
In a former life these were the mottos that were drilled into us and which proved to be enormously successful. They still are.
Black Swans and Correlation are what kill. Key is to constantly be moving your stops and redoing the hedges. But when the Black Swan flies you're likely to get hit badly, no matter what. Stops don't execute fast enough. The beta on hedges can change dramatically. But Black Swans tend to drive nearly everything in an asset class, and across many asset classes that are supposedly not correlated, in the same direction. So rebalancing rarely reduces risk as much as advertised. Better to follow the trend and maximize the gains, and just be prepared to take a big haircut at some point.

 

[Mountain Trader]

I think my best answer to Julian is that, yes, he should not worry about rebalancing because he has not set up a balanced portfolio to begin with. Instead, he picks dividend paying stocks and that's it, if I read his posts correctly.

Now I think that's a good class of assets. So good that I own a Schwab fund that does only that-hold dividend paying stocks. But just owning that one class excludes many others, in fact all others that don't pay dividends. So while this may turn out well or not, there is no attempt to balance among other classes, so there is no way to rebalance.

 

[Julian Brennan]

Matt you assume that everyone is seeking alpha and the one who doesn't should stick to REITs and index funds? Since 100 investors have 100 different goals it doesn't work like that. The idea with the Schwab dividend ETF is not bad, in fact I tried it before. The income these kinds of investments generate, however, is far inferior to what can be achieved by actively picking the best cherries out of the market basket. A large fund manager or computer with billions or trillions in assets simply cannot do that.

Hence my thesis that portfolio rebalancing is overrated/overplayed because it is (for me) unneccessary in the first place.

 

[Matt]

Matt you assume that everyone is seeking alpha and the one who doesn't should stick to REITs and index funds?

Pretty much, yes. I see an index fund strategy as being most able to reflect the market as a whole - it is broadly diversified with low costs. If people want to pick stocks it is because they are chasing returns above the market as a whole.

Since 100 investors have 100 different goals it doesn't work like that.

I don't think that there are 100 different goals. I think there are people who haven't realized how the market works and try different things, but long term, goals are the same.

Schwab dividend ETF is not bad, in fact I tried it before. The income these kinds of investments generate, however, is far inferior to what can be achieved by actively picking the best cherries out of the market basket.

Here is where the logic fails. If you actually made any real money out of what you were doing 'picking the best cherries' you'd have enough money to just leave it in the ETF and that be sufficient. But if you are playing around with small numbers the excitement of a 10 bagger is huge.

Again, if you can make even $40K MORE than an Index strategy by trading in your spare time, why not just quit and do it full time?

 

[Hanaleiradio]

Here is where the logic fails. If you actually made any real money out of what you were doing 'picking the best cherries' you'd have enough money to just leave it in the ETF and that be sufficient. But if you are playing around with small numbers the excitement of a 10 bagger is huge.

Again, if you can make even $40K MORE than an Index strategy by trading in your spare time, why not just quit and do it full time?

I assume that you're being provocative, intentionally, with that last sentence! I know several people who consistently beat an index strategy who are not full time traders. Most people are not cut out for the grind of full time trading, and most of us choose to spend our time on things that are personally more rewarding. I know many, including yours truly, who are a lot happier working for nonprofits than they were investing full time. Although, I would agree that an index strategy makes a lot of sense for passive investors that don't have an interest in investing (a large majority.)

In the thread's introduction you said that Portfolio Rebalancing is simply a way to reduce risk. For involved investors, there are often more effective ways to reduce risk than rebalancing. Shorting widely-traded ETF's is a common one. Great thing about ETF shorts is that the danger of being squeezed into oblivion is significantly reduced from shorting equities or commodities directly, as the short position in any large ETF is always going to be much greater, and ETF managers manage against having short squeeze exposure. Use of option spreads and straddles is another.

But IMHO, the big problem with most risk reduction strategies is that when they're needed most--which is when things fall apart badly--they fail to provide the amount of protection that was projected. In a global financial system that over the last 20 years has increasingly become prone to boom and bust, it has become very difficult for all investors, but particularly the small ones, to adequately manage risk.

 

[El Ingeniero]

Absolutely. My original purpose for the thread was to show how rebalancing fails to perform. I think it's noteworthy when all these robo brokers claim alpha, but their actual performance is below the market, and has been since inception.

But it's much better than that of the average investor, including the average professional.

 

[El Ingeniero]

I don't think that there are 100 different goals. I think there are people who haven't realized how the market works and try different things, but long term, goals are the same.

More useful distinction is investors with discipline, and investors without. And we can also graduate from short investment horizon (minutes) to long investment horizon (lifetime).

IMO, investors without discipline lose always. Investment horizon simply changes how you respond to the environment. Of course, when long term investors all of a sudden become short term (a la Black Friday), you get market crashes and instant runups.

 

[Matt]

I assume that you're being provocative, intentionally, with that last sentence! I know several people who consistently beat an index strategy who are not full time traders. Most people are not cut out for the grind of full time trading, and most of us choose to spend our time on things that are personally more rewarding. I know many, including yours truly, who are a lot happier working for nonprofits than they were investing full time. Although, I would agree that an index strategy makes a lot of sense for passive investors that don't have an interest in investing (a large majority.)

In the thread's introduction you said that Portfolio Rebalancing is simply a way to reduce risk. For involved investors, there are often more effective ways to reduce risk than rebalancing. Shorting widely-traded ETF's is a common one. Great thing about ETF shorts is that the danger of being squeezed into oblivion is significantly reduced from shorting equities or commodities directly, as the short position in any large ETF is always going to be much greater, and ETF managers manage against having short squeeze exposure. Use of option spreads and straddles is another.

But IMHO, the big problem with most risk reduction strategies is that when they're needed most--which is when things fall apart badly--they fail to provide the amount of protection that was projected. In a global financial system that over the last 20 years has increasingly become prone to boom and bust, it has become very difficult for all investors, but particularly the small ones, to adequately manage risk.

Only going from my own experience I find most people who trade make bold claims but aren't able to really understand the risks and the rewards that they are achieving. It lends itself to the younger person and the get rich quick crowd. With that in mind, I focus my comments to that crowd also.

I do believe it is possible for someone to have the skills to trade effectively, but I think that is 1 in 100 (and I am being kind here) unfortunately I can't really ask people to pony up their brokerage account performance for the past 10 years, but if I could I would. That would be very telling (most wouldn't have that much history).

I do truly believe that the vast majority of people who are trading as a 'hobby' while working ful time are not beating the market, and of those that do, I believe that the alpha isn't overly impressive when you include time value. In your case, you talk of hedged investments, which are smart, but if you hedge you are losing upside by definition, so I can't see that it would outperform a relatively straightforward index fund strategy by much.

Note, I am not saying I doubt YOU know what you are talking about, heck even Julian might know what he is talking about, but I think most people don't.

 

[Hanaleiradio]

Only going from my own experience I find most people who trade make bold claims but aren't able to really understand the risks and the rewards that they are achieving. It lends itself to the younger person and the get rich quick crowd. With that in mind, I focus my comments to that crowd also.

I do believe it is possible for someone to have the skills to trade effectively, but I think that is 1 in 100 (and I am being kind here) unfortunately I can't really ask people to pony up their brokerage account performance for the past 10 years, but if I could I would. That would be very telling (most wouldn't have that much history).

I do truly believe that the vast majority of people who are trading as a 'hobby' while working ful time are not beating the market, and of those that do, I believe that the alpha isn't overly impressive when you include time value. In your case, you talk of hedged investments, which are smart, but if you hedge you are losing upside by definition, so I can't see that it would outperform a relatively straightforward index fund strategy by much.

Note, I am not saying I doubt YOU know what you are talking about, heck even Julian might know what he is talking about, but I think most people don't.

I agree with nearly everything you state, including the < 1/100 ratio. Its very very hard for a part time investor to beat the overall market over 10 years. And the worst thing that can happen to a part-time "hobbyist" is to score big for a year or two when they're starting out. They get to where they know enough to be really dangerous, and never learn that risk mitigation is the only factor that matters in sustaining success. I've seen more than a few lose 2 years of profit in a week's time because they thought that what worked for a few years would work forever. Its also extremely hard for part-timers to sustain interest for 10 years. Using ETFs in an index strategy makes a lot of sense for most.

Hedges are very tricky, and it takes time to learn how to use and maintain them properly. They do lose upside, particularly in periods of low volatility, but the protection on the downside when things get crazy usually more than compensates for the incremental loss to the upside. But not always!

 

[Julian Brennan]

And again, it seems like there's no distinction between different sorts of let's say market participients. You keep on talking about TRADERS. For me that's the guy trying to find the next 10 bagger with a certain scheme or without a clue.

But that's not the type of guy I'm talking about. I'm talking about INVESTORS, ppl who have a goal in mind which may be anywhere between 5 and 50 years away in the future. We are not traders, we are investors. We buy shares of successful, mature businesses and not some paper tickets which happen to go up or down on any certain day. We don't care about daily or quarterly or annual price fluctuations to make a quick buck (unless we're sitting on too much cash and the market crashes in which case we're instantly embarking on a shopping spree paid for by Wall Street). That's where the infamous blindfolded monkey comes into play.

 

[Hanaleiradio]

And again, it seems like there's no distinction between different sorts of let's say market participients. You keep on talking about TRADERS. For me that's the guy trying to find the next 10 bagger with a certain scheme or without a clue.

But that's not the type of guy I'm talking about. I'm talking about INVESTORS, ppl who have a goal in mind which may be anywhere between 5 and 50 years away in the future. We are not traders, we are investors. We buy shares of successful, mature businesses and not some paper tickets which happen to go up or down on any certain day. We don't care about daily or quarterly or annual price fluctuations to make a quick buck (unless we're sitting on too much cash and the market crashes in which case we're instantly embarking on a shopping spree paid for by Wall Street). That's where the infamous blindfolded monkey comes into play.

And so what methods does an "investor" in "successful, mature businesses" use to mitigate risk? Or does such an "investor" just rely on his or her amazing analytic prowess to pick "successful, mature businesses" and then sit back and let it ride? If its the "let it ride...the cream always rises to the top and the market always comes back" strategy, then using that strategy in 2005-07 would have resulted in a minimum of 4-7 years of net zero returns (or losses), even with "successful, mature businesses"--which was the same result as those who simply plopped their money into naked index funds.

 

[Mountain Trader]

At YE 2006, the Dow was around 10,700. Now, 8 years later, it's 17,660. That's a compounded, internal rate of return of about 6.5% a year, even with the big drop that began in 2008. Plus dividends.

To get that return, all one had to do was keep their fingers off the keyboard, and take their heart medicine.

 

[Hanaleiradio]

At YE 2006, the Dow was around 10,700. Now, 8 years later, it's 17,660. That's a compounded, internal rate of return of about 6.5% a year, even with the big drop that began in 2008. Plus dividends.

To get that return, all one had to do was keep their fingers off the keyboard, and take their heart medicine.

On 1/1/2000 the SPX was at 2010.28.
On 1/1/2006 the SPX was at 1,534.93
On 1/1/2014 it stood at 1854.42.

That's 14 years of no gains--actually a loss--if one simply kept their fingers off the keyboard and played an equity index without hedging. One would have actually made out much better by being 100% in treasuries.

http://www.multpl (dot)com/s-p-500-price/table

Its valuable to look at historical charts or tables of asset values. What one sees is how both the frequency and the volatility of boom and bust cycles have increased in the last 20 years--which makes risk management more important than ever.

 

[Mountain Trader]

On 1/1/2000 the SPX was at 2010.28.
On 1/1/2006 the SPX was at 1,534.93
On 1/1/2014 it stood at 1854.42.

That's 14 years of no gains--actually a loss--if one simply kept their fingers off the keyboard and played an equity index without hedging. One would have actually made out much better by being 100% in treasuries.

http://www.multpl (dot)com/s-p-500-price/table

Looks like someone should have been rebalancing along the way.

 

[Julian Brennan]

And so what methods does an "investor" in "successful, mature businesses" use to mitigate risk?

He/she uses time to his/her advantage. Many ppl talk about the "lost decade" of stock returns. Well this may be true for "traders" or folks who solely rely on price appreciations. Dividends however have increased manyfold over this time period and have provided solid income streams for their shareholders. There's a reason why WB is so rich. He doesn't trade and he doesn't care about market prices. He cares about cashflow and sustainable growth.

 

[JoeK]

Only going from my own experience I find most people who trade make bold claims but aren't able to really understand the risks and the rewards that they are achieving. It lends itself to the younger person and the get rich quick crowd. With that in mind, I focus my comments to that crowd also.

I do believe it is possible for someone to have the skills to trade effectively, but I think that is 1 in 100 (and I am being kind here) unfortunately I can't really ask people to pony up their brokerage account performance for the past 10 years, but if I could I would. That would be very telling (most wouldn't have that much history).

I do truly believe that the vast majority of people who are trading as a 'hobby' while working ful time are not beating the market, and of those that do, I believe that the alpha isn't overly impressive when you include time value. In your case, you talk of hedged investments, which are smart, but if you hedge you are losing upside by definition, so I can't see that it would outperform a relatively straightforward index fund strategy by much.

Note, I am not saying I doubt YOU know what you are talking about, heck even Julian might know what he is talking about, but I think most people don't.

What Julian is doing is pretty much the polar opposite of trading. It is a slow, steady accumulation of stocks which pay consistent dividends. Over time, the compounding starts to add up, and before you know it in 15-20 years you have a nice income generating machine at work.

The beauty of this approach is that the market performance (and by that I mean the stock price) of the companies being invested in doesn't matter. The investor is relying on the dividend payouts, which are much more consistent even through major recessions or other market crashes.

While the index investor certainly isn't wrong, it's just a different approach and it relies very heavily on market returns which can be wild and inconsistent over time. I don't want to have to worry next time there is a recession and the market takes a 50% dive. When that happens, my income will increase because I am holding companies that make steady income through recessions and have not cut their dividends in 10, 20, or even 50+ years.

It's a similar rationale to those that buy rental properties. The main factor is the rental income keeps coming in. It doesn't really matter if the market value of the property goes higher or lower, if you aren't planning on selling. The advantage of dividends over rental properties is far fewer headaches/maintenance in the long run.

 

[rforest117]

I don't re-balance. It has become more difficult for me to find good investments and as such I just buy more of what I already own. I am rethinking the re-balancing after reading your post on tax loss harvesting. I have been reading a lot of compelling posts about just owning a total market EFT as a way to "set it and forget it" investing but aside from convenience, unless you are in a bull market your returns would be mediocre. This post has given me lots to think about.