The Compound and Friends - The Hype Behind Portfolio Rebalancing (Tadas with Peter Lazaroff)

Episode Date: May 13, 2019

“Rebalancing is getting a little overrated. It is nowhere near as impactful on returns as human and digital advisors advertise. I also feel like human advisors probably rebalance more than is truly necessary.” Peter Lazaroff who is the co-CIO of Plancorp and BrightPlan. Peter blogs at PeterLazaroff.com and most importantly for the purposes of this discussion is the author of the recently published book Making Money Simple: The Complete Guide to Getting Your Financial House in Order and Keeping It That Way Forever. We recently published a two-part Q&A with Peter on Abnormal Returns: part one and part two. You can read more about Peter at his blog: https://peterlazaroff.com/blog Enable our Alexa skill here - "Alexa, play the Compound show!" https://www.amazon.com/Ritholtz-Wealth-Management-LLC-Compound/dp/B07P777QBZ Talk to us about your portfolio or financial plan here: https://ritholtzwealth.com/ Obviously nothing on this channel should be considered as personalized financial advice just for you or a solicitation to buy or sell any securities. Please see this 3,000 word terms & conditions disclaimer if you seriously need this spelled out for you. https://thereformedbroker.com/terms-and-conditions/ Hosted on Acast. See acast.com/privacy for more information. Learn more about your ad choices. Visit megaphone.fm/adchoices

Hey, Peter, it's Tadis. Hey, Tadis, how's it going? Hey, I'm good. I'm on the line with Peter Lazaroff, who's the co-CIO of PlanCorp and BrightPlan, and Peter blogs at PeterLazaroff.com. And most importantly, for the purposes of this discussion, he is the author of the recently published book, Making Money Simple, The Complete Guide to Getting Your Financial House in Order and Keeping It That Way Forever. I recently published a two-part Q&A with Peter on abnormal returns, so you can check those posts out for a deep dive into some of the topics of the book.

But today, we are going to talk about the idea of portfolio rebalancing. So, Peter, portfolio rebalancing seems to be everywhere today. I would argue that it's table stakes for advisors and robo-advisors. So, what is portfolio rebalancing? And is there something controversial about it that I'm missing? Well, portfolio rebalancing is really all about maintaining the initial asset allocation. So at a high level, just the initial stock bond targets that you were set out to do when you build the portfolio. And what that means is if you start with a 80% stock portfolio, 20% bond portfolio, as the market goes up, the proportion of stocks grows from, say, 80% to maybe 85%. And then that means you need to sell some stocks and buy some bonds to bring that back in balance.

And there's really two things that are important about that. The first one is that, well, hey, then you get to buy low and sell high on different asset classes. So that's pretty cool. But most importantly, in my opinion, it's really just about maintaining that initial risk exposure that you signed up for in the first place. Now, US, is there anything you're missing? I am definitely a fan of rebalancing, but I also think that the hype around rebalancing has maybe gone a little far recently, particularly as robo-advisors have become more of a, I don't know, a household kind of term and more people are using them, the adoption rates are higher. And initially they were kind of selling their services based

on the value add of rebalancing and all those value add studies. And Vanguard actually has one that's part of the value of an advisor, which is great, but I don't know that you can point so specifically to a consistent return ad because it's all dependent on the types of accounts you have, the number of holdings, the market conditions, the time period. And so generally I get a little frustrated when people say, yeah, but we're rebalancing. So we're adding a lot of value. I do think you're adding some value behaviorally because if the market's down, it's great to rebalance. It gives somebody something to do, feel like they're doing something, not just sitting around and watching. And then similarly, when the market's up, if your portfolio is becoming too stock heavy and you very intentionally picked a certain allocation out the gate,

well, that's important to get it back there. But I definitely think that it's super important. It's kind of a commodity at this point. It's not necessarily something that differentiates one advisor from another. Anyone who is managing money, whether it's a human or a digital platform, is rebalancing in some form. And whether their rebalancing rules are right is a whole other discussion. Yeah, no, I think that's right. I think the only thing that you can guarantee with portfolio rebalancing is the second thing you said is that you bring your portfolio back to the original sort of risk

metrics that you had in mind when you put it together. Everything else in terms of the returns are really dependent upon what the market does. Absolutely. And I'm not totally sure that if you just made it about a risk story that people would buy into it, people being the end investor would buy into it being that important. And so maybe that's why we all do somewhat fall into the return benefit as well. The return benefit feels more anecdotal. I mean, it's definitely there if you go back and say rebalance one time a year on January 1st each year. But you can also find periods where that isn't true if you just pick the right time period. And I've certainly done a lot of research myself in trying to create

the right rebalancing rules internally here. And the short story of it all is there really is no such thing as an optimal rebalancing system. The most important thing is to have a set of rules and stick to them no matter what. And then all the results come out pretty similar from there. Yeah, no, you can drive yourself crazy trying to work through all the different sorts of iterations of rebalancing rules. But it kind of gets to one of the points that you made in our Q&A and that you also made in the book. And the idea is that there really is no perfect portfolio. And kind of by extension, there's really no perfect portfolio rebalancing system, et cetera, et cetera.

So the pursuit of perfection is kind of wasted effort for investors, both professional and individual. I like that you said that the pursuit of perfection is really a problem, particularly in rebalancing, because oftentimes people will think that because they're supposed to have some specific decimal point or specific percentage in a certain asset, that that's some magical number. When in reality, as I think of how we build our model portfolios and construct our portfolios, there is a lot of science behind it. But there is also a degree of art where the one or two

percentage points difference between a certain asset class or a certain holding is really not changing things in the grand scheme of things. And so we, for example, on rebalancing use tolerance bands where we don't rebalance according to a calendar schedule. It's when these tolerance bands get violated, when the asset swings above or below some threshold. But generally speaking, the tolerance bands, in my opinion, ought to be pretty wide because we don't know that we have the perfect allocation. We have something that's really reasonable based on a lot of time and thought in science. But generally speaking, I do know that some assets are more volatile than others, and those bands ought to be wider to account for that because the perfection or lack thereof is so relevant in that specific area. Yeah. No, I think the other thing about portfolio rebalancing is that, you know, it is also dependent upon the individual, dependent

upon your tax situation, dependent upon whether your assets are in an IRA, a 401k, or a taxable account, and the degree to which that you have inflows into the portfolio that help you sort of ease that sort of rebalancing process. And so, you know, even for, you know, we could talk about portfolio rebalancing rules, but in that regard, everybody's portfolio is just a little bit different. Right. Well, and gosh, if portfolio performance could be accurately reported in an after-tax manner, it would change the whole framework of rebalancing for a lot of people. But unfortunately, there's just not a lot of portfolio management software.

Well, there are no portfolio management software systems that accurately will allow an advisor to show what an after-tax return is and have it be accurate and meaningful to the client. But if they did, boy, this would all look a lot different at the decision-making and the advice-delivering process. Yeah, it's interesting that you mentioned taxes. And I think one of the other things that kind of almost oftentimes goes hand-in-hand with portfolio rebalancing is the idea of tax-loss harvesting. And I think all the arguments that we're making about portfolio rebalancing could probably be made about tax loss harvesting as well. Sure. It's really important, but how important? And all else equal, when you're tax loss harvesting, you're really just deferring taxes. Now, there's times when tax loss harvesting is done more strategically to offset a gain from

the sale of a business, or maybe you're using an SMA that gives you an index return while spitting off a lot of losses that you can use to whittle down concentrated positions or prepare for a liquidation event. That's all different. But the run of the mill, hey, the market's down 10% or 20%, so we're going to sell this large cap fund and buy another large cap fund in its place. Again, there's no reason not to do it. But really really you're just deferring the taxes and that isn't without value. But the research is actually kind of split on at the end if it's really all as beneficial as what it sometimes gets advertised as. Yeah, no, absolutely. I think, like we said, there is a mechanical aspect of tax loss harvesting, which is kind of ideally suited for kind of the robo-advisors

of the automated systems in the world, which they can do those mathematics and those trades pretty easily. But like we were talking about portfolio rebalancing, nobody knows what tax rates are going to be in the future. And, you know, maybe deferring gains into the future is good. Maybe it's bad. Maybe it's, you know, maybe deferring tax, maybe deferring gains into the future is good. Maybe it's bad. Maybe it's, you know, maybe it's all a wash, but, you know, it is a bit of a bet on, it's a bet on what the future is going to look like. And unfortunately, none of us know what that is. Well, and here's something you can't quantify, but just like rebalancing, there's

a behavioral benefit to tax loss harvesting. I think when the market's down, the most important thing for investors to do is stay the course. And so if that means creating activities that are probably helpful in the long term, but in a worst-case scenario are break-even in terms of helpfulness, but it allows them to do something and then stay the course, well, then that's great. And so I think tax-loss harvesting gives people something to hang their hat on and feel like they're doing something in response to this emotionally-filled, scary set of circumstances that tend to arise when markets are falling. And the 10% and 20% drops are really normal, but the 30%, 40%, 50% drops, boy, it's nice to be able to make some lemonade out of the lemons in that situation. And tax-loss harvesting, at its worst, is helpful there.

At its best, it really does have some value in the long term for tax deferral. Or again, for people who are doing it more routinely as part of a liquidation event strategy or trying to diversify out of concentrated positions. Yeah, no, I think that idea of the behavioral aspects of both of these strategies makes perfect sense. And I think that's probably a great place to leave things. Peter, thanks very much for your time. We'll talk to you later. All right.

Thanks, Titus.