What if I told you that there were lots of things you could do that would guarantee a higher probability of providing for your retirement than just rebalancing your portfolio?
First, let’s look at why annual rebalancing isn't as important as the gurus would have you believe.
The rule of thumb is that you should look at your overall portfolio and aim to have 110 minus your age invested in equities, with the rest in fixed-income instruments. As one asset class grows or shrinks more than the other, over time, your allocation may get out of whack, necessitating rebalancing of your assets to get back to the magic formula.
David Swensen of Yale in his book Unconventional Success: A Fundamental Approach to Personal Investment, states that proper rebalancing can add 0.4 percent to your annual returns.
First, we’ll examine why a 0.4 percent change in your returns won’t have a material impact on your retirement, and then we’ll look at what you other things you can do to get an even better return on your money.
Let’s take the example of a 25 year old named Bob who makes $50,000 and gets a 3 percent raise every year. This person is reasonably diligent in saving and investing. He saves 10 percent of his income, or $5,000 and gets a 7 percent return annually without rebalancing. This means, according to Swensen, if he does it right, he’ll get a 7.4 percent return with appropriate rebalancing.
If Bob works to age 65 and doesn't rebalance, he’ll have $1,693,645.62 in his investments. If he rebalances, he’ll have $1,868,692.04. If you assume a 4 percent withdrawal rate, then he’ll be able to withdraw $5,645.49 a month if he didn't, and he’ll be able to withdraw $6,228.97 a month if he did rebalance. While annual rebalancing will have gained him 10.3 percent more cash each month, this difference is highly unlikely to make or break Bob in retirement. He may have a slightly lower standard of living from not rebalancing, but, as you’ll see below, rebalancing is not the key to whether or not Bob can retire. What are the things that Bob can do which will earn him more over his lifetime than rebalancing?
- Save more of a percentage of his income. If Bob saved more than 11.03 percent of his income, he’d wind up with more money than what he gets from rebalancing. That’s $43.07 a month more. Surely Bob could find $43.07 a month more to save without having to start eating cat food.
- Retire later. Depending on the year Bob was born, he could get between 5.5 percent and 8 percent a year more in Social Security, which is a much higher return than rebalancing.
- Negotiate a higher salary. If Bob can increase his salary at age 25 to $55,167.74 or more, he will have more in investments at 65 than he does by earning a lower salary and rebalancing.
- Invest in funds with lower fees. Find a fund that charges 0.4 percent less of an expense ratio, and you’ll get the same return as rebalancing.
- Create his own business. Even if it’s a side gig that pays him occasionally, as we’ve seen, he needs to increase his income by 10.3 percent to maintain savings rate and be just as well off.
Believe it or not, I’m not the only one preaching this. Researchers from the Boston College Center for Retirement Research took three different approaches to evaluate the impact of asset allocation and came to the same conclusions.
Annual rebalancing, if done properly, is an important piece of the retirement puzzle. Nobody will turn down an improvement of 0.4 percent in their investments; however, it’s only one piece, and relying solely on rebalancing will not get you to there.
Jason Hull is a candidate for the CFP(R) Board's certification, is a Series 65 securities license holder, and owns Hull Financial Planning.