Retirement Portfolios - When to Rebalance?
Introduction
The question
of how often to rebalance a portfolio in retirement is a complex one. For one thing,
one must consider whether the rebalancing is done in a taxable or nontaxable
account or a combination of the two. Clearly, there are negative implications
for those who must rebalance within taxable accounts. Triggering taxable
events often negates the advantages of periodic rebalancing. The advice
from most investment professionals seems to be that one should consider
rebalancing their portfolio every year, if not every quarter. This of
course can trigger quite a few taxable events and transaction costs,
particularly with quarterly rebalancing. With this
in mind, I wanted to look at retirement portfolio performance as a
function of rebalancing less frequently than what most investment advisers
recommend.
Method
I
put together a small study showing historical 100%
SWRs
(inflation adjusted portfolio safe withdrawal rates) for 1927-2002 using different asset classes. I looked
not only at the conventional year-end
rebalancing but also at rebalancing
at various thresholds, either by percentage change in the components of the
asset mix or by time multiples of the base one year period.
The data comes mostly from the Global Financial Data
sample series (http://www.globalfindata.com/):
The pre-1994 small cap value (ScV)
data comes from Kenneth French's data library:
French's Library
The post-1993 data is the actual S&P
SmallCap 600/Barra Value index data:
Barra
The pre-1994 ScV data was
extracted from the deciles of French's "25 Portfolios Formed on Size and
Book-to-Market (5 x 5)" file which most closely match the S&P
SmallCap 600/Barra Value index data. I chose this
approach since currently the best widely available ScV index
fund is, in my opinion, the S&P SmallCap 600/Barra Value
index ETF (ticker: IJS).
As for the mechanics of the study, I looked at
withdrawal periods up to 55 years starting in 1927 through 2002. This means
only about 21 were full 55 year periods and the rest (about 55) were partial. I used expense ratios of 0.25% for the S&P500, 0.4% for
ScV, 0.35% for EAFE, and 0% for
Treasury Inflation-Indexed Securities
(TIPS) and T-bills. Expenses were taken
out at the start of each year.
TIPS have only been available since the
late 1990's so their performance history is short. I simply modeled them at the historical CPI-U
inflation rate plus a fixed coupon which I arbitrarily chose at 2.5%. In
reality this approach more closely models TIPS' cousin, inflation
indexed US savings bonds (I bonds), but the differences are not great and it is easier to
implement in software code.
Results:
In the table below under rebalancing,
values for '0%' and '1yr'
are the same since at 0% (or greater) change the portfolio is rebalanced every
year. 'X%' means that the portfolio is rebalanced only if at least one of the
components changes by X percent or more from its base value at the end of the year (5% means, for example,
that T-bills now comprise at least 30% or less than 20% of the portfolio rather than
a targeted
25%). 'X yr' means
rebalancing every X years regardless of percentage changes in the
portfolio. The last column, 'None', means no rebalancing at any time.
| S&P500 |
ScV |
EAFE |
TIPS |
T-Bills |
|
1 yr |
2 yr |
3 yr |
5 yr |
|
0.0% |
5% |
10% |
None |
| 75% |
|
|
|
25% |
|
3.8% |
3.6% |
3.7% |
3.7% |
|
3.8% |
3.7% |
3.8% |
3.7% |
| 25% |
25% |
25% |
|
25% |
|
4.5% |
4.4% |
4.5% |
4.5% |
|
4.5% |
4.7% |
4.6% |
4.3% |
|
75% |
|
|
25% |
|
4.5% |
4.9% |
4.9% |
4.3% |
|
4.5% |
4.5% |
4.6% |
4.1% |
| 25% |
25% |
25% |
25% |
|
|
4.9% |
5.1% |
5.1% |
4.6% |
|
4.9% |
5.0% |
4.7% |
4.4% |
|
60% |
|
40% |
|
|
5.1% |
5.4% |
5.4% |
4.5% |
|
5.1% |
5.1% |
4.9% |
4.4% |
| 38% |
|
38% |
|
25% |
|
3.9% |
3.7% |
3.9% |
4.0% |
|
3.8% |
3.9% |
3.9% |
3.8% |
| 75% |
|
|
25% |
|
|
3.9% |
3.9% |
4.0% |
3.9% |
|
4.0% |
4.0% |
4.0% |
3.9% |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Average SWR: |
4.4% |
4.4% |
4.5% |
4.2% |
|
4.4% |
4.4% |
4.4% |
4.1% |
Conclusions:
One probably should rebalance
periodically. As you can see, the average SWR for the theoretical
portfolios is less for the non-rebalanced portfolios compared to those that
were periodically rebalanced. However, the differences are not that
great and if one has to rebalance within taxable accounts then he or she may
want to consider rebalancing with considerable restraint, if at all.
Diversifying outside the S&P500 and cash (T-bills)
really does help. This is not really a surprise given what we know about
diversification and the "free lunch" it provides.
A simple Coffeehouse-type
portfolio (The
Coffeehouse Investor) split evenly between S&P500, EAFE, ScV,
and T-bills would've increased the SWR by a hefty 0.7% per year (4.5% versus
3.8% for portfolios rebalanced every year) over a 75:25 S&P500:cash
portfolio. I think that this is a great option,
particularly if you believe in the efficient market dictum that all
asset classes should perform about equally on a risk-adjusted basis going
forward. By the way, being able to withdraw an extra 0.7% per year is
huge. This means that you could withdraw nearly 20% more from your
portfolio each year.
ScV
was the real star performer during this time period but should be balanced with other equity classes
or a sizeable dollop of fixed income to offset volatility. TIPS work
especially well with ScV. At the time of
this writing ScV
also is currently undervalued relative to the S&P500 and I would expect its
outperformance to continue in the future, maybe
even by a wider margin.
Even if one is rebalancing within nontaxable accounts
the rebalancing really doesn't have to be done every year. In fact, you
might be better off rebalancing only after your portfolio components get
seriously out of whack by 5-10% or every 3 years or so. Even in a
nontaxable account there may be some transaction costs involved so decreasing
the frequency of rebalancing may be desirable even if taxes are not a
consideration. In fact, I believe that there may be a reason that
rebalancing about every three years seems to work just as well, if not
slightly better, than rebalancing more frequently. Wm. Bernstein has
shown that there is some
momentum effect,
albeit weak, with regard to short-term domestic and foreign equity returns . As you can see in the table above, there is a very slight
advantage to rebalancing every third year versus the other strategies.
The effect is so slight that I doubt that it is statistically significant.
However, both Bernstein's research and my own tend to indicate that mean
reversion does not occur over periods much less than three to four years and
that there may be some benefit to following the weak momentum that equity
markets seem to exhibit prior to reversion to the mean.
Last edited:
06/23/2004