Why Rebalancing Doesn’t Work in Stock Portfolios

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Beyond Buy-and-Hold #23

I advocate Valuation-Informed Indexing, an investing strategy in which you change your stock allocation in response to big swings in stock prices, going with a high allocation when prices are good and a low allocation when prices are unappealing. This is the opposite of Buy-and-Hold, a strategy in which you stay at the same stock allocation at all price levels.

Rarely does anyone object that valuations don’t affect long-term returns. Just about everyone accepts this. The objection that I most often hear is that valuations do indeed matter but that rebalancing, a practice followed by Buy-and-Holders, is a sufficient response to the problems caused by rising valuations. This is the most widespread misperception about how stock investing works present among the stock investors of today.

I believe that the problem may be rooted in a misunderstanding of what the word “overvaluation” signifies. Overvaluation in the stock market rarely causes immediate problems. For example, stock prices rose to insanely dangerous levels in 1996. But it was not until 2000 that the Lost Decade for stock investors began. Those of us who ignored valuations were able to get along for four full years without paying a penalty for having done so. To the contrary, those going with high stock returns in 1996, 1997, 1998, and 1999 enjoyed amazing short-term rewards.

We humans by nature have a short-term focus. When we hear about overvaluation, do nothing in response to what we hear for four years, and suffer no penalty as a consequence, we come to believe that this overvaluation thing just is not that big a deal.

The reality is that overvaluation is a very big deal indeed. To appreciate why rebalancing is such a poor response to the problem of overvaluation, you need to first appreciate just how alarming a state of affairs has come into existence for stock investors when the market comes to be insanely overpriced.

Overvaluation is mis-pricing

Please ponder that three-word sentence for a moment. Try to let in to your consciousness what is being signified by the word “overvaluation” when it is spoken in reference to the stock market in which you are investing to finance your retirement.

Say that you were about to buy a car and a friend you trust called you and told you that in the deal that you had been offered by a dealership the car was mis-priced. Would you shrug your shoulders? Would you pronounce this information bit to be one of no great consequence? Would you go ahead and sign on the dotted line anyway?

You wouldn’t. If you heard from someone you trust that in the deal for a car you wanted to buy the car was mis-priced, you would be alarmed. You might not nix the deal. You would certainly hold back from signing your name to a contract until some changes were made.

You would investigate further. You would ask hard questions. Unless you obtained good answers to your questions as to why the deal you had been considering called for you to accept a car that was mis-priced, you would be off to another dealer in a quest of a more reasonable offer.

Why don’t we respond the same way when stocks are mis-priced?

We don’t respond to stock mis-pricing that way. That’s why most of us obtain lifetime returns far less than the average long-term return of 6.5 percent real. That’s why most of us have over the past 11 years suffered investing setbacks serious enough to bring on an economic crisis.

Say that there are 10 possible levels of risk for investors, with Level One representing Extreme Low Risk and Level Ten representing Extreme High RIsk. Say that you possess a risk tolerance for which Level Five Risk is acceptable but for which risk levels greater than Level Five RIsk are problematic.

When the P/E10 level is 7 (half of fair value), the fair-value magnet (stocks always move in the direction of fair value in the long term) is pulling the P/E10 level up hard and there is virtually no chance of a valuation drop (we never go below 7). So you could go with an 80 percent stock allocation and still enjoy a Risk Level Two for your portfolio.

However, when the P/E10 level is 28 (double fair value) the magnet pull is pulling the P/E10 level down hard and there is a virtual certainty of a stock crash (we have never gone to a P/E10 of 28 and not experienced a crash in the following years). So an 80 percent stock allocation would at that price level translate into a RIsk Level Ten.

Why would the same investor go with a Risk Level Two at one time and at a Risk Level Ten at another time? This makes no sense.

Rebalancing does not solve the problem. To keep your risk profile roughly constant in the face of wild price swings, you need to change your stock allocation dramatically in the face of big valuation shifts. Rebalancing assures that your stock allocation remain the same. What you want is to be sure that your stock allocation changes dramatically (so that your risk level remains roughly constant).

Don’t rebalance. Be sure always to change your stock allocation as needed to keep you at the right stock allocation for someone with your risk tolerance.

Rob Bennett developed a unique portfolio allocation calculator. His bio is here.

( Photo by Smiles Are Free )

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2 Responses to Why Rebalancing Doesn’t Work in Stock Portfolios

  1. I really enjoyed this post.

    I think what is hard with stock is knowing when stock is overvalued. You can look at P/E ratios (I also like the PEG ratio), but P/E ratios can vary by industry also. (A 25 might be considered high in consumer goods, and maybe it is acceptable in tech. Not saying that is the case, just illustrating an example. Although I don’t think I would buy P&G if the P/E was 25…)

    Risk level is important, but I do think people need to evaluate what their risk level should be given the stage of life they are at. It might not be a good idea to focus on small cap stocks if you are retiring in the near future.

    Loved the car analogy. It really got me thinking.

  2. Thanks for those kind words, Everyday Tips. They brought a nice measure of cheer to my Wednesday afternoon.

    Two thoughts re the P/E Ratio:

    1) One of the reasons why most of us don’t know about good tools by which to assess valuations is that the popularity of Buy-and-Hold Model discourages us from developing them and learning about them. Buy-and-Holders don’t change their allocations in response to big price swings. So valuations don’t matter to them in any practical sense. If most investors shifted to Valuation-Informed Indexing, there would be a huge demand for effective valuation assessment tools. And I believe we would get them.

    2) P/E10 (the current price of the S&P over the average of its last 10 years of earnings) is the best valuation metric, according to most of the people who put a big focus on valuations (Shiller, etc.). So this is the tool I use. However, even P/E10 is far more powerful when used to value a broad index fund rather than an individual stock.

    I believe that the biggest reason why many people do not yet appreciate the great power of valuation-informed strategies is that index funds have only been around for a few decades and people just have not yet caught up with the implications of this huge change in how stock investing is done. There’s nothing wrong with investing in individual stocks. But returns are FAR more predictable when you invest in index funds and use a valuation tool to set your allocation.

    The reason is that an index fund contains a mix of good and bad companies. So all of the factors affecting success are essentially held constant. All that you need to be concerned about are that the U.S. economy remain roughly as productive as it has been for many, many years and that valuation levels are reasonable when you buy your index fund. Do that and you are set. It has never before been so easy to obtain great returns while taking on remarkably little risk.

    Bogle changed the history of stock investing by making index funds widely available to middle-class investors, in my assessment. I don’t think that even Bogle realizes today how important an innovation he advanced!

    Rob

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