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Should Portfolio Rebalancing Be Considered Market Timing?
By JLP | May 5, 2008
I’m in the midst of reading a new book by Christopher Jones titled The Intelligent Portfolio
Jones, who is the Chief Investment Officer of Financial Engines, writes that people who invest using a fixed-proportion portfolio (i.e. 70% stock/30% bond portfolio) are essentially market timing when they rebalance their portfolios. Why? Because the act of rebalancing requires the selling of an asset class that is “overvalued” and using the proceeds to purchase another asset class that is “undervalued.”
I’ll have to admit that I never really looked at in this way but I can see his point. I always considered rebalancing as a prudent way to limit risk. If a person desires a 70/30 portfolio of stocks and bonds, over time the percentage of their portfolio that is exposed to stocks will increase as stocks typically appreciate faster than bonds. Take a look at the graphic below to see what I mean:
Assuming a 10% rate of return for stocks and a 5% rate of return for bonds, in ten years this portfolio would nearly become an 80/20 portfolio. For a personl only desiring a 70% exposure to stocks, an 80% allocation would seem inappropriate.
So my question to you is:
Is portfolio rebalancing the same thing as market timing?
I’m not far enough into the book to tell you what the author’s view on this topic is. I’ll be covering more of this book in the near future.
Topics: Asset Allocation, Books, Investing | 17 Comments »
May 5th, 2008 at 12:37 pm
I don’t think so. In my mind at least, market timing is buying or selling based on expected short-term future price changes. And I would define rebalancing as reacting to *past* short-term price changes to bring your portfolio back into line with your plan.
So that is where I see the difference, past vs. estimated future.
May 5th, 2008 at 12:49 pm
In my opinion rebalancing is not the anything like the same as market timing because the rebalancing is arbitrary in timing and has nothing to do with shifts in market sectors. But from the example given it seems dumb. Why take assets out of something earning 10 percent to put them in something earning 5 percent. To complete the example you should show what would have happened at 10 years if you rebalanced for instance at 5 years. Result obviously would be lower result.
best wishes
May 5th, 2008 at 12:53 pm
If you rebalanced once a year on a set date, say at the first of the year, I don’t think that is market timing. But if it is done in a less methodical manner, then it surely could be considered market timing.
May 5th, 2008 at 1:09 pm
No, rebalancing is not the same thing as market timing. As you noted, it’s just a way to maintain the same level of risk in your portfolio.
It has nothing to do with being “overvalued” or “undervalued”. There’s certainly no reason why rebalancing couldn’t result in selling an “undervalued” asset class for an “overvalued” one.
For example, REITs had fantastic growth for several years, before crashing down. At what point exactly where they “overvalued”? Had you rebalanced each of those years you would have sold REITs, but they would have kept going up.
Also, it confuses the issue by suggesting that rebalancing can increase returns (by using the terms “overvalued” and “undervalued). It can’t (a priori). The only reason you rebalance is to keep the same risk in your asset allocation.
May 5th, 2008 at 2:21 pm
Market timing is bad because you can’t do so reliably, but if you found a way you would make a lot of money. Rebalancing is what drives returns precisely because it is a reliable means of market timing.
John, 5% and 10% are average returns, but real returns will be more volitile; diversifying here means that when the market crashes, you will lose less, and have more to invest at new, low prices.
May 5th, 2008 at 2:34 pm
I guess technically it is market timing since it’s basically a trading strategy.
On the other hand, is market timing really so bad if it’s done for the right reasons?
Mike
May 5th, 2008 at 2:52 pm
Market timing is considered a bad thing and I have no idea why. I always time the market. I made my full Roth contributions a few weeks ago when the market was so beat down. Should I have waited for a rally? No, not if I felt the market was undervalued. People who lose money buy high and sell low. I always time the market – it isn’t a bad thing – its the only thing that does make since and its what value investors do.
Look at BNI – Buffett bought his huge share a few months ago and paid around $75 a share for it cause he deemed it a good value at that price. Today its trading around $104/share. Was Buffett timing the market? Of course – that’s how he paid what he considered a fair or even undervalued price.
May 5th, 2008 at 3:19 pm
I have yet to hear a what I consider a convincing argument for asset rebalancing in the first place. To use your example above, why is a 70/30 percent stock/bond ratio good? Where did the ratio come from? Why is a 75/25 percent ratio five years later bad? Seems to me that these ratios are just pulled out of the air. Are there any heavy duty financial calculations involved here. A risk analysis or probability analysis? Maybe it is because the ratios alway seem to be some multiple of 5 or 10 percent that bothers me. Maybe if my ideal stock/bond ratio was 68/32 I might be more impressed with the concept.
May 5th, 2008 at 3:47 pm
Given the uncertanties of the stock market, if someone suggests a very specific ratio then they are probabl trying to bamboozle you. In general, it seems like you want proportions that aren’t too small, so rebalancing will have a large effect, and you probably want to concentrate a little extra in areas that tend to be better performers (stocks). Low correlation among your assets is what really matters.
May 5th, 2008 at 6:53 pm
Yes this is market timing, and buying stocks and reselling them 5 years or 10 years later is also market timing (for example, if you need the money for college or a down payment on a house). There is nothing illegal or unethical about market timing.
The mutual fund scandals from a few years back was FRAUD not market timing. Select people got to buy shares on the previous days closing price, which was unethical and illegal.
The financial industry wants to brainwash people that market timing is wrong because they want more assets to manage. The more money they manage the more profits they earn. They want you to leave your money with them forever (buy and hold).
May 6th, 2008 at 7:50 am
In response to Sam and Ian, while the 70%/30% may be contrived in this scenario, I believe there is a method for determining the optimal (theoretically at least) portfolio allocation using Modern Portfolio Theory. Based on your risk tolerance (max allowable standard deviation in yearly returns), you can select a portfolio that optimizes your ROR and minimizes your risk. I am not an expert on MPT, but check out this link to get an overview and some examples. It gets a little math and statistics intensive, but who doesn’t love math!!
http://www.moneychimp.com/articles/risk/riskintro.htm
May 6th, 2008 at 12:04 pm
I don’t think that portfolio rebalancing a portfolio on a quarterly or annual basis is market timing. Rebalancing on a each month is probably market timing.
I think the purpose of rebalancing is to realign your portfolio with your risk tolerance and to preserve gains from the bond or stock markets. Failure to rebalance could expose an investor to a higher amount of risk than they’re comfortable with. Benjamin Graham’s ‘The Intelligent Investor’ does an excellent job of describing why rebalancing a portfolio composed of bond & stock holdings is important. Since these markets usually move in opposite directions, taking gains from a bull stock market and placing them in relatively cheap bonds will help preserve the stock gains when the stock market falls and bond market rises. The opposite is also true. So, rebalancing quarterly or semi-annually ensures that you’ll not have to time the sale of your holdings from a bull market because you’ve been dollar-cost averaging their sale for months or years. It’s the exact opposite of market timing if done with discipline and an indifference to the state of the market.
May 6th, 2008 at 12:18 pm
Market timing is betting you know what the market is going to do. Reallocating is admitting that you do not know what the market is going to do and you are willing to reduce potential future gains in return for less volatility. Reallocating is the only way I know to consistently sell high and buy low. Believe me, I have tried every other way!!!
May 6th, 2008 at 2:17 pm
Don’t finish the rest of the book – this author’s statement is hogwash. Market timing is about expected return, looking at the heart of the distribution of potential outcomes. Rebalancing is about minimizing risk – looking at the left-sided tail of the distribution.
May 6th, 2008 at 11:47 pm
I think Scott hit the nail on the head, and the first thing I though of when I read this post was Benjamin Graham. There is an interview published shortly before his death where he touches on this issue, a reprint can be found at http://www.bylo.org/bgraham76.html, I posted my thoughts on this interview and my thought on rebalancing as Scott has described Graham’s position was that it isn’t market timing. You are locking in your gains by rebalancing, not trying to maximize them by timing the market.
May 7th, 2008 at 9:40 am
I prefer to rebalance (my 401k) by adjusting my contribution allocations for the first couple of months of the year. On the first of the year I take a snap shot of my portfolio and assume everything will remain frozen there. I then calculate the balanced amount for each fund assuming I can make a lump sum contribution to avoid selling any shares. I then adjust my contribution allocation over the next several pay periods to meat this balanced portfolio, while ignoring any changes since my snapshot. When I have finished with the balanceing I return to allocating my contributions with the same distribution as I would like to keep in my portfolio.
Since either this method or the standard buy and sell method involve basing decisions on the market at a certain point in time, you are technically timing the market. In my opinion, market timing involves lump sum investing with the goal of buy low and sell high, whereas if you are making regular contributions in a set allocation you are time-averaging instead of market timing even though you are trying to maintain a set portfolio allocation over time.
July 19th, 2008 at 3:56 pm
Rebalancing works great in moderate markets, but what about giant bubble markets like what we have seen with Real Estate and now energy? When an educated person knows in their heart that things are about to go really bad (the Sheeple are all “in the market”) What do we do then?
Put the rebalanced strategy on hold and go to cash or is there another strategy that works that is not so severe? These bubbles tend to last longer than we think they will and the drop is quick and severe, so mechanical strategies may not hold out for these situation.
Bubble markets are obvious and hard to miss. Some sort of timing strategy makes sense for these.
Those that track markets understand when the implications when a market is well beyond the normal range. Has anyone run across research on bubbles? Do you follow a different strategy change for these special market conditions?
Thanks!
-Bryan