Balancing

This page is about balancing your investments each year.  It’s a technique that I’ve seen mentioned and heard of friends using, but I’ve never found maths to justify it.  So here’s some maths and some interesting conclusions.

The underlying idea is to cash in a year of high growth in one investment and rebalance it into an investment that has underperformed this year and (you hope) will bounce back.  It’s supposed to take the tinkering human out of the equation (holding investments too long, selling low and buying high), and instead have a process that can be followed automatically.  It can be applied across a portfolio:  e.g. every June you rebalance your investments to be 40% UK Income, 20% North America, 20% Corporate bonds, 20% Gilts.

What’s in the tables

In this analysis there’s “Equity” which achieves 8.3% annual return, “Flip” which rises when equity falls though not so volatile, “Cash” with a constant and generous 3.49%, “Corporate Bond” which moves in phase with equities but is much less volatile, and “Low-volatility equity” which achieves 8.4% but with less volatility (and is of course totally unrealistic).  For three of the scenarios we have all-equities but their falls and recoveries are out of phase by a defined number of years.

The columns to the left show the annual performance of the two investments over 22 years. Then you see the performance if we leave the investments independent and don’t balance, starting with both valued at 100.  Then the year end values if we balanced at the end of the previous year (and you also see that balanced figure).  Finally there’s the ratio of the balanced total divided by the independent total:   over 100% in year 22 means that balancing has helped.

Conclusions

First remember that I value growth.  I do not have a problem with volatility.  If you have a problem with volatility then you might make some different conclusions.

Second remember that hindsight is a wonderful thing.  In these examples all equities return 8.3%, cash returns 3.49%, etc..  Should you invest in Emerging Markets Growth in the  hope of holding an investment that performs as well as North America but with different phasing?  Or would you be better with South East Asia?  In real life, the best performance could come from 100% investing in the one thing that outperforms everything else, but who knows which that is?

I see that in pretty much every case, it is better to rebalance than to leave funds alone.

I see that the best final total comes from investing in high-growth investments.  Blending equity-bond or blending equity-cash might reduce volatility but it doesn’t reach the heights that blending equity-equity achieves (assuming equities perform best!!).

I see that balancing equities that are slightly out of phase gives best results (a crash in one lines up with a recovery from a crash in the other).

I see that more volatile investments balanced with each other do better than less volatile investments balanced with each other.  This leads to a rather horrible conclusion:  artificial instruments that amplify the performance of an equity market (deeper losses, greater rises) balanced with an out-of-phase amplified investment perform best.  Whatever you think of the suitability of such investments, a follow-on is that people stand to benefit from stock market volatility and therefore some will work to achieve it.

So overall, don’t be surprised if I continue to chase high-growth equities.  I rebalance rather thoughtfully – trying to anticipate the imminent growth area and being overweight there – and I know I hang onto one or two great performing funds or shares (Rio Tinto), when probably I shouldn’t.  Perhaps I should just balance automatically.