A Canadian's random thoughts on personal finance

Jan 31, 2010

Rebalancing: has John Bogle lost his mind?

Larry McDonald's recent blog post discusses some critiques of dividend investing. I can't say I'm either for or against dividend investing, but one of the critics is John Bogle, who pretty much invented indexed mutual funds.

As blasphemous as this may seem, I tend to take Mr Bogle's advice with a grain of salt after reading his arguments against rebalancing. Saying rebalancing is unnecessary is essentially saying that asset allocation is unimportant.

This is clearly goofy. How does Mr Bogle justify this stance?

He justifies it by demonstrating that the additional returns from rebalancing are negligible. Well, as a believer in the efficient-market hypothesis, I could have told you that.

Rebalancing is not about maximizing returns. It's about managing one's exposure to risk. In fact, I'm actually mildly surprised that a rebalanced portfolio beat a non-rebalanced one at all. That means you are getting reduced risk at no cost! It seems to be one of the few free rides available in the investing world.


Michael James said...

I saw Bogle's arguments against rebalancing differently. While the past 20 years showed an edge for rebalancing, over the long term it has lost out. It won 52% of the time, but when it won the margin was small, and when it lost, the margin was bigger. So, non-rebalancers have a higher return expectation.

It's true that the real reason to rebalance is to control risk. I think Bogle's concern is that the amount of risk-reduction is very modest and definitely not worth paying an advisor for. There are many types of funds that promise rebalancing and even automatic risk reduction while approaching a target date, but their costs are almost always many times the expected benefit.

I read Bogle's response to mean "rebalance if you want, but don't pay for it."

Patrick said...

@Michael: Good point. To give Bogle the credit he deserves, he does say that rebalancing may be a good idea when the asset mix wanders too far from your target. I suppose he was referring to scheduled (e.g. annual) rebalancing.

Ethan said...

Just read Bogle's statement on rebalancing. I'm still investigating this concept myself, and have read Bernstein's look at the topic here: http://www.efficientfrontier.com/ef/996/rebal.htm

One thing I was left wondering after reading Bogle's response was, how far off target did their research portfolio's get and what did that doe to their sharpe ratio? I mean, saying that rebalancing won only very marginally and is therefore ignorable is a reasonable conclusion if return is the only thing you are looking at. But we look at risk as well.

Surely the portfolios that did not rebalance nearly always ended up with a higher equity component than the ones that did, meaning they would have ended up with higher volatility as well. Yet the rebalanced ones, on average, actually outperformed slightly. If that is the case then it represents a huge victory for rebalancing, not a tie: rebalancing would have allowed investors to enjoy the same returns or better with less risk.

I agree that it seems odd for John Bogle to be either wrong or even just imprecise about this. I'm about the read the Boglehead's book, so I'll see what they have to say about it. Great blog... found it from a post of yours on Swedroe's column.

Patrick said...

Thanks, Ethan! I'd be interested to hear your conclusions once you reach them.