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Sunday, October 3, 2010

Asset Allocation Model and Rebalancing

There are some thrilling Sunday conversation topics for you.

In any case, I realized that I neglected to post what the asset allocation model said for September. Suffice it to say that it still points toward the same 80/20 split in favor of equities that it has since we have been modeling it. However, after the increase in stock prices in September and a slight narrowing of corporate credit spreads, the overall score wasn't quite as strong. Remember that the model has minimum asset allocations of 20% bonds or equities no matter how favorable the indicators become for one asset class or another.

In any case, now might be a good time to discuss that even with fixed asset allocations like this there are some nuances that you have to take into account regarding re-balancing. If you rebalance every month where you assess your actual allocations compared to the targets, a result many don't think of is that, even with static asset allocations, you do end up accumulating more of the underperforming asset class at its bottom. I've actually gotten some confused looks from people on this point so I will explain it in a clear example.

For example, let's say that you have $100,000 (most of us wish) split 80/20 stocks and bonds respectively. In the course of three months, the stock portion of your portfolio loses 25% and the bond portion rises 10%. You will have a total of $82,000 split $60,000 stocks and $22,000 bonds. Inadvertently, bonds have become about 27% of your portfolio. In order to bring your portfolio back into the proper balance, you take $5,600 out of your bonds and put it into your stock positions to restore your target weightings. In this way, even when your portfolio takes an overall beating due to possibly being overexposed to equities in a bad stretch for them you still buy in at the lows even though it would otherwise appear that you can't commit any more to equities. This isn't exactly a shocking revelation, but it is one that some people don't think of.

Now, if you have a $5,000 portfolio or even a $10,000 portfolio as opposed to a $100,000 portfolio, the transaction costs involved here probably either come close to or entirely eliminate the gains from very frequent rebalancing. If you rebalance every month, you have two transactions at $10 a piece for $240 in a year, not to mention the capital gains you might accumulate in the process. This is one persistent problem for smaller portfolios versus larger ones which is that you are more wedded to individual investment decisions due to a lack of flexibility in getting out of them.

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