The Bogleheads' Guide to Retirement Planning (22 page)

Risk is a fundamental part of return. Higher returns are not possible without taking some risk. However, it is possible to construct portfolios that maximize expected return for a particular level of risk. These optimal portfolios occur along what is called the efficient frontier. Plotting differing combinations of assets results in an efficient frontier curve where you can see that for every level of return, there is one portfolio that has historically had the lowest possible risk, and for every level of risk there is a portfolio that has historically had the highest return. If you can construct portfolios that are on the efficient frontier in the future, then you have found MPT nirvana.

Figure 8.1
illustrates an efficient frontier curve of two assets: U.S. stocks and international stocks from 1970 to 2008. The chart plots U.S./international combinations in 10 percent increments. Over the time period represented in the chart, the 100 percent U.S. portfolio had a higher return than the 100 percent international portfolio. During the same period, the international portfolio was riskier because it had a larger variation of year-to-year returns.

Looking at
Figure 8.1
, you may wonder why anyone would invest in international stocks at all if the returns were lower and the risk was higher. It does not always occur this way. First, the risk and return of any asset class depend on the time period measured. Second, the return of the combined 70 percent U.S. and 30 percent international portfolio was higher than either asset class alone, with the added benefit of less risk than either asset class by itself. A portfolio that includes multiple types of assets has different risk and return characteristics than the individual assets in the portfolio. A multiple-asset allocation reduces the impact on your overall portfolio from the big ups and downs of one single type of asset.

Source:
MSCI and S&P

Modern portfolio theory explains that portfolios on the efficient frontier are best because they offer the highest expected return for any given level of risk and the lowest risk for any given return level. The portfolios on the efficient frontier naturally tend to be the ones that are the most diversified. Less diversified portfolios tend to fall short of being the most efficient.

A portfolio’s asset allocation between stocks, bonds, and cash determines the portfolio’s overall risk and return characteristics. Historically, stocks have returned more than bonds, so more of a tilt toward stocks should mean higher expected long-term returns. There is, of course, a trade-off. Stocks have also historically been more volatile than bonds, so more of a tilt toward stocks also means larger short-term ups and downs. As 2008 demonstrated, some of these downs can be very large.

Over time, your portfolio of stocks, bonds, and cash will probably drift from the allocation targets you set. That means your portfolio will have a higher or lower stock-to-bond ratio than you originally intended. In turn, the portfolio’s risk and expected return will also have changed, sometimes significantly. Since your portfolio’s target allocation should change only when your investment goals change, the portfolio needs to be put back in line. Rebalancing is the primary method used to realign a portfolio with its stated risk and return objectives. Rebalancing means adjusting your portfolio to restore its original target allocation.

During a strong bull market in stocks, a 60 percent stock and 40 percent bond portfolio might become a 70 percent stock and 30 percent bond portfolio because of the high return on stocks. This means that your portfolio value has grown, but it also means your portfolio is now riskier, and you have more to lose if stocks go into a bear-market downturn. Rebalancing back to your original 60 percent stock and 40 percent bond position will bring your portfolio back to your desired risk profile.

In a different year, during a bear market, your balance may tip in the other direction, with your stock allocation dropping from 60 percent to 50 percent. Your portfolio has now become more conservative than your original target. You would then have less money invested for growth, possibly lowering your future returns. So again, rebalancing back to your original 60 percent stock and 40 percent bond allocation will bring your portfolio back to your desired profile.

Rebalancing also has the added advantage of forcing you to buy low and sell high. As an asset class falls in price, rebalancing means you buy more. As an asset class rises in price, rebalancing means you take some profits. Investors without a rebalancing plan often react emotionally and do just the opposite—buy high and sell low—to the detriment of their overall portfolio value.

Rebalancing controls risk, but when should you do it? There is no one-size-fits-all strategy. The optimal time to rebalance is different over different time periods, and it is not possible to know in advance what rebalancing strategy will be optimal. There are some considerations. Rebalancing may involve costs (as described in the costs section later in this chapter), and these costs have to be weighed against your tolerance for risk, relative to your target allocation. Generally, though, there are two major methods: rebalancing after a certain time period (by the calendar) or after your allocation changes by a certain amount (percentage bands).

A straightforward time frame to use for checking if your allocation is out of whack is once a year. Waiting longer means you run the risk of letting your allocation percentages drift too far from their targets and your desired portfolio risk level. This method is simple and requires little time to implement. Rebalancing more often runs the risk of making changes in reaction to temporary market moves.

Another advantage of using time-period rebalancing is that you don’t have to constantly monitor your portfolio. Not looking at your portfolio every day may help you stay the course, limiting your temptation to panic-sell during a bad market downturn.

After a year has gone by, you may find that your portfolio is not far out of balance. This may have occurred because the markets did not move much or because you have been rebalancing when making contributions or withdrawals throughout the year. If a certain time period has elapsed and your portfolio is only slightly out of balance, it often brings up the question of whether it’s even necessary to rebalance at all.

Rather than rebalancing by the calendar, many people make changes only when their portfolio allocations are off by a certain percentage. A commonly used number is 10 percent, meaning that someone with a 60 percent stock and 40 percent bond portfolio would rebalance if their stocks went up to 66 percent or down to 54 percent (10 percent of 60 percent equity is a 6 percent band). They wouldn’t make any change if the stock percentage had changed only a little, say, up to 63 percent or down to 59 percent. Using this method allows your allocation to fluctuate enough that rebalancing may actually be required less often. This would be especially beneficial in a taxable account, as rebalancing less often would mean fewer potential taxable transactions. A disadvantage of using a percentage rebalancing method is that it requires more effort to implement, as you need to continuously monitor your portfolio, rather than just looking at it once or twice a year.

A popular compromise between the two methods is to use annual monitoring with actual rebalancing done only when the balance has tipped outside a percentage threshold. This creates a balance between controlling the portfolio risk and minimizing any rebalancing costs.

The method for doing rebalancing really doesn’t matter as long as you are consistent. In addition to deciding when to rebalance, it’s important to consider how to rebalance, so as to minimize any potential tax consequences.

For both taxable and tax-advantaged accounts, if you are still making contributions to your investment accounts, the simplest way to rebalance is to use new money to purchase shares of the asset class that is most underweighted. Each time you have new money to invest, simply look at your asset percentages and put the money in the one that needs a boost to bring it back to its normal weighting. This will generally mean that you are purchasing the asset class that has either appreciated the least or has even gone down recently, so you are buying low. This is also a very tax-efficient way to rebalance, as it doesn’t involve any selling of assets, which could result in a taxable capital gain.

If you are no longer making contributions to your investment accounts and are in retirement and taking withdrawals, you can use this method to rebalance by just doing it in reverse. Each time you need to withdraw money from your investments, simply look at your asset percentages and take the money out of the one that is overweight. This will generally mean that you are selling the asset class that has appreciated the most recently, so you are selling high, which is a good thing.

In a taxable investment account, it’s especially important to be aware of how any rebalancing may affect your tax liability. If you sell shares in a taxable account to move money to another fund, you may realize a capital gain and be required to pay taxes. So in a taxable account, it’s best to keep any selling to a minimum. One way to rebalance a taxable account is to use the cash that the account is already generating through fund distributions. Any time a fund pays a distribution in a taxable account, you have to pay taxes on it, whether you reinvest the money or not. So if you choose to not reinvest distributions back into the same funds that paid them, you can instead use the money to rebalance, by purchasing shares of your underweighted asset classes. The amount of the distributions may not always be enough to totally rebalance, but it will at least lessen the number of shares you may have to sell from the overweight asset class, minimizing tax consequences.

In a tax-deferred portfolio such as an IRA or 401(k), taxable events aren’t an issue. When it comes time to rebalance your portfolio, simply sell shares of the assets that are over their target percentage, and use that money to buy shares of those that are under their target. But in a taxable portfolio, every sale of shares in one of your mutual funds is something that gets reported on your tax return and potentially increases your tax liability. So, while selling shares to rebalance is straightforward, a taxable-account investor should aim to limit tax liability and use this method only after the others have been exhausted.

All investing involves costs and paying expenses of some sort, either directly or indirectly. These costs come out of your investment profits. And taxes paid further reduce your gains. The investment profit you actually keep equals your investment gains minus expenses, minus fees, minus taxes. Lower overall costs—in the form of expenses, fees, and taxes—allow you to keep more of the profit that your investments have earned.

Anyone investing in a mutual fund pays a share of the costs necessary for the day-to-day operation of the fund. If a brokerage firm holds your investments, you may also pay a transaction cost to buy or sell no-load mutual fund shares. Shares held directly with a no-load fund company will not be charged a trading commission.

The expense ratio is the cost incurred by the fund to operate. It includes the cost of paying the manager of the fund and the costs of services to the clients of the fund. Client services can include providing fund prospectuses and annual reports, monthly or quarterly account statements, and a toll-free telephone number for contacting the fund. The basic expense ratio of the fund is disclosed in the fund’s prospectus.

An expense that is not directly spelled out in the prospectus but is born by the shareholders is the indirect cost of trading securities in the fund. The cost of transactions in a fund is based on the turnover of securities and the trading spread of those securities. Mutual funds that buy assets in relatively illiquid markets may find that even though the actual commission to buy is low, the trading spread between the buy and sell prices is high. And if a fund is attempting to buy or sell a particularly large quantity of any security, the fund’s own buying and selling may result in a price movement of that security. That market impact cost is not measured in the prospectus. Trading costs are minimized by low-turnover funds such as index funds.

Exchange-traded funds avoid market impact cost by creating and redeeming securities in kind rather than in cash. However, when buying or selling ETFs on an exchange, there is a spread on the fund itself that represents the cumulative spreads of securities in the fund.