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Asked & Answered: Buy & Hold vs Rebalancing

July 20, 2010

 

Harold from E. Hampton, NY writes:

 

Is “buy and hold” the best strategy?  I have heard conflicting perspectives.  What do you think?

 

Friedenthal Financial:

 

Good question!  There has been a lot of research suggesting that active management rarely beats the broader indexes (buy-and-hold) when all expenses are incorporated.  However, much of this research was conducted a long time ago (some from the late 60’s and 70’s).  The investment landscape in general has changed a fair bit, even in the last 10 years.  Some of these changes have materially reduced some of the impediments of an actively managed portfolio.  Consider the following.

 

Transaction expenses (both commissions and bid-offer spreads) are a small fraction of what they once were.  An investor might spend $10 on transaction expenses today that would have cost several hundred dollars 30 years ago!  In addition, some ETFs and Mutual Funds give investors very cost effective ways to invest in a variety of equities, (foreign and domestic), fixed income (corporate and sovereign credit, municipals, inflation protection securities) and even some commodities.  The drastic reduction in expenses, coupled with improved access to varied markets, removes some of the historical impediments of achieving superior results to a buy-and-hold strategy.

 

For most people, investment needs change as they get closer to retirement.  In addition, portfolios can deviate materially from the investor’s target as the market fluctuates and cash accumulates.   A thoughtful approach to portfolio rebalancing helps keep an investor’s portfolio in line with their target and is easy for the typical investor to implement.

In addition, Friedenthal Financial uses a tactical allocation approach to alter which sectors and classes are represented in our portfolios as market conditions change.  This requires more time and discipline, and is not advisable unless the appropriate time and resources can be devoted to such a strategy.

 

Below is comparison of simply owning 50% S&P 500 and 50% of a broad Investment Grade Bond Index (dividends automatically reinvested) vs. rebalancing as the portfolio deviates from its target.  Note that rebalancing is ONLY one of the techniques described above.  This example does NOT adjust for the investor’s age NOR does it employ any type of tactical asset allocation.  It is a simple illustration of the benefits of rebalancing to a desired target, which is relatively easy for most investors to execute.

 

 

 

 

 

(Click to view chart in new window)

 

 

 

(Click to view table in new window)

Data source: Bloomberg

 

Chart Details:

 

Assumptions: These are gross returns without any adjustments for taxes.  This would be akin to a tax-deferred account, such as an IRA.  To illustrate a realistic simulation, $15 per transaction was used to account for brokerage fees and Bid/Ask spread.  Transaction cost and individual tax consequences may vary and should be considered before implementing any investment strategy. 

 

The chart above shows the effects of rebalancing on a portfolio consisting of 50% S&P 500 and 50% Citigroup Broad Investment Grade Bond Index from 6/30/1980 through 6/30/2010.  The “Buy and Hold” portfolio represents the effects of buying these indexes on 6/30/1980 and reinvesting dividends throughout the entire period without any transactions.  The “Rebalancing at 10%” portfolio represents a rebalance whenever the weights of the positions deviate by more than 10% from the target (i.e. target of 50% is rebalanced if it becomes >60% or < 40%).  The “Rebalanced Quarterly” portfolio represents a disciplined rebalance of the portfolio to its target first day of each calendar quarter.

 

As depicted in the chart above, a simple rebalancing method improves returns and reduces risk.  While the 0.40% increase in annual returns (10% deviation vs. Buy & Hold) may seem modest, the value achieved over a 30 year period is substantial, as illustrated by the difference in the value of $1 invested in 1980.  At the same time, volatility of returns, as measured by annualized standard deviation of monthly returns, is actually lower when the portfolio is rebalanced.  Using a quarterly rebalancing approach produces some improvement over the Buy & Hold strategy, although falling short of the 10% deviation method.  It is illustrated since it may appeal to investors for its simplicity of execution.

 

In addition to rebalancing, some active portfolio management strategies include tactical asset allocation.  In making such tactical changes to a portfolio, investors should consider fundamental characteristics of alternative sectors or classes, macroeconomic views (inflation, unemployment, growth, etc.), and technical trends.  We also examine covariance between sectors and classes, which evolve over time.  Sound tactical allocation may improve risk/return profile and systemic risk reduction.  Careful consideration to all relevant risks should be considered when adjusting a portfolio.

 

We hope that helps and provides fodder for discussion.  Please let us know if we can be of further service!

 

The Friedenthal Financial Team

 856-210-6494 (Office)

 856-210-1565 (Facsimile)

info@friedenthalfinancial.com

www.friedenthalfinancial.com

 

Please send us your questions!!   If we don’t know the answers, we’ll find someone who does!

 

If you know someone who would like to discuss their investment needs with us, we certainly appreciate the introduction.

 

This blog is only intended to provide answers to questions of general interest we receive on the topics of investments, finance, capital markets, and economics and to serve as a historical repository for our e-mailed Asked & Answered column.  We are not rendering or offering to render personalized investment advice or financial planning advice through this blog or any of its attached links.  Friedenthal Financial will render investment advice to potential clients only after:  (i) we have delivered a disclosure statement to the potential client as required under applicable securities laws, and (ii) the potential client has executed and delivered Friedenthal Financial’s investment advisory contract to us.  We will provide investment advisory services to clients only in states in which Friedenthal Financial is registered as an investment adviser or is exempt from registration.