Thursday, December 29, 2011

Positive Returns in Volatile Markets

Last year I wrote a long post concerning the whys, wherefores and how tos surrounding rebalancing your portfolio. Calendar year 2011 isn’t yet over and anything could happen in the last two days of the year. However, unless the last two days are really bad, my net worth will increase in 2011.

As a reminder, I’m retired and have no income except from my investments. That means I was able to live off my investments and still have more at the end of the year. For this retiree, that is a successful investing year.

So in another twelve-months that most pundits are chalking up as one more “lost year,” after already “losing” the first decade of the 21st century, how did that happen?

I have two answers: diversification and rebalancing.


In another post I set forth my then asset allocation policy:

Bonds (44.0%)
    Short-term                     Balancing Item
    Medium-term                       4.0%
    Long-term                            0.0%
    Inflation-protected               15.5%
    Pension                               Actual%

Equities (50.0%)
    US Large-cap                       23.0%
    US Small-cap                       10.5%
    Europe                                  7.5%
    Pacific                                  3.5%
    Emerging Markets                  5.5%

Other Real Estate                      3.0%
Commodities                             3.0%

Total (100% )

The only changes I made to my asset allocation policy during the year were to reduce the medium-term bonds to 2.0% and decrease the Inflation-protected bonds allocation to 14% —both reflecting the lowering real rates of return. I kept the overall bond/stock/other allocations the same, temporarily moving the additional funds into money market accounts (where they are earning next to nothing).

Bonds increased in value through the year as the Federal Reserve continued downward pressure on interest rates, helped in large part by the instability in the rest of the world that made US treasuries look relatively rock-solid. The US stock market was mostly sideways or down for the year. Foreign securities were down a bunch, especially valued in US dollars. Commodities were up, down and now sideways. Real Estate Investment Trusts (REITs) added value during 2011.

Since I have more money in stocks than bonds and a higher proportion of international stocks than most, with a buy and hold strategy without rebalancing I would have generated a decrease in total asset value worse than the average bear.

Yet even after living expenses, I ended up with an increased net worth. Is this some new application of Wall Street math? No, it’s not. In 9 ¾ years of retirement and following my strategy of diversification and rebalancing, my net worth has increased about 45%. Diversification has helped even out my returns, as has periodic rebalancing.


The markets did not go uniformly up or down; they rollercoastered throughout the year. I rebalanced four times during 2011. I should have done it more often, but was distracted by other things. This is particularly true of my commodities position, where rebalancing would have earned me a better return. Live and learn.

Rebalancing is particularly useful in volatile markets. In some sense it forces you to sell when an asset is high and buy when it is lower. Looking at my actual purchases and sales of the Vanguard Index 500 Fund in 2011 shows how this worked to my advantage.

In January I sold shares at 117.59. In February the index increased and I needed to sell more shares to rebalance, which I did at 120.54. By September the index had declined to 111.37 and I needed to buy shares to rebalance. By December, I had to rebalance again, primarily because of the declines in international equities and sold most of the shares I bought in September at 116.48.

The gains are not huge, but they did earn about 5% on those funds that I would not have earned had I not rebalanced. Don’t confuse this with market timing where one attempts to pick the bottom to buy and the top to sell. Had I been prescient, I would have sold all my stock at the beginning of the year and put it into long-term bonds. Only my need to rebalance dictated the timing of the purchases and sales.

This strategy is about hitting lots of singles, about picking yourself from the dirt when the markets throw a bean ball and being prepared for the next pitch whatever it may be. If I were to fault myself for this year’s performance it is that I should have rebalanced a bit more often to reflect the increased volatility.

~ Jim

No comments:

Post a Comment