The Fallacy of Rebalancing Revisited
Financial advisors routinely adhere to the discipline of rebalancing portfolios, so much so that they invest tens of thousands of dollars in software to automate the process. That adherence has been regularly reinforced by financial writers. I show why this conventional wisdom is wrong and rebalancing may be as unwise an investment as the software used to do it.
I have had three articles on rebalancing published in Advisor Perspectives since 2014. The first was on April 15, 2014, on whether rebalancing adds to return; the second on April 22 of the same year, on whether rebalancing reduces risk; and the third and most comprehensive on August 16, 2016. Recently Bob Huebscher, Advisor Perspectives’ CEO, sent me several articles on rebalancing that had been published since that time by Morningstari, Michael Kitcesii, and Larry Swedroeiii. He suggested that I respond to them.
They all suffer from exactly the same defect.
Nothing to fear but fear itself
On March 4, 1933, in the depths of the Great Depression, U.S. president Franklin Delano Roosevelt uttered in his inaugural address the 10 words that comprise one of the most justly famous sayings of modern times: “The only thing we have to fear is fear itself.”
This saying was not only uniquely true at the time, it applies in many situations. We often fear something most because of the fear it will induce rather than the rational fear of actual harm.
For example, the fear can be great of a shark attack or a bear attack when a lover of the outdoors swims in the ocean or hikes in the woods. But the risk of death from a lightning strike is about 100 times greater than either of those risks. People may fear more the desperate panic they believe would be induced by a bear attack or a shark attack than they fear the risk of death itself.
Similarly, people with acute fear of flying are afraid of the panic that would grip them if the plane experienced violent turbulence. And yet the risk of turbulence is not the actual risk; it is, of course, the risk of a plane crash.
Articles that advocate rebalancing often suffer from a similar fallacy of misplaced concreteness. The real risk in investing is the risk of failure to achieve one’s financial goals. But what is identified as “risk” in all the articles on rebalancing cited above is not the risk of failing to achieve one’s goals, but the risk of “turbulence” – i.e. market volatility.