Bogleheads® Live

Colleen Jaconetti: Rebalancing Your Portfolio

December 12, 2022 Colleen Jaconetti Episode 33
Show Notes Transcript

[00:00:00] Jon: Bogleheads® Live is our ongoing Twitter Space series where the do-it-yourself investor community asks their questions to financial experts live on Twitter. You can ask our questions by joining us for the next Twitter Space. Get the dates and times for the next Bogleheads® Live by following the John C. Bogle Center for Financial Literacy on Twitter. That's @bogleheads.

[00:00:22] For those that can't make the live events, episodes are recorded and turned into a podcast. This is that podcast.

[00:00:29] Thank you for joining us for the 33rd Bogleheads® Live, where the do-it-yourself investor community ask questions to financial experts live. My name is Jon Luskin, and I'm your host. Our guest for today is Colleen Jaconetti, returning for her second time on Bogleheads® Live.

[00:00:47] Let's start by talking about the Bogleheads®, a community of investors who believe in keeping it simple, following a small number of tried-and-true investing principles.

[00:00:56] This episode of Bogleheads® Live, as with all episodes, is brought to you by the John C. Bogle Center for Financial Literacy, a 501(c)(3) non-profit organization dedicated to helping people make better financial decisions. Visit our newly designed website at to find valuable information and to make a tax-deductible donation.

[00:01:17] Before we get started on today’s show, a disclaimer. This is for informational and entertainment purposes only, and should not be relied upon as a basis for tax, investment, or other financial planning decisions.

[00:01:27] Let's get started on today's show with Colleen Jaconetti. Colleen Jaconetti is a Senior Investment Professional at Vanguard with 28 years of experience, including financial planning with a specific focus on after-tax wealth management, retirement income, portfolio construction, advice methodology, and model portfolios.

[00:01:45] She created original Vanguard thought leadership on such topics as tax-efficient drawdowns, dynamic spending, asset location, total return investing, and today's topic: rebalancing.

[00:01:57] Speaking of total return investing, you can listen to the 26th episode of Bogleheads® Live where Colleen demystifies dividend investing, debunking that popular but suboptimal investing approach. I'll link to that in the show notes for our podcast listeners.

[00:02:15] Colleen Jaconetti, thank you for joining us on today's Bogleheads® Live. Let's start with a little bit of “Rebalancing 101.” What is rebalancing and why should we rebalance a portfolio?

[00:02:24] Colleen Jaconetti: If you're thinking about, from a financial planning perspective, one of the first things that people would do would be to select an asset allocation. So that would be the percentage that they would invest in stocks, bonds, or cash.

[00:02:35] And that would be based on their time horizon, their risk tolerance, and their goals. And the reason why asset allocation is important is because it really determines the risk and return profile for a given portfolio. 

[00:02:44] Over time, different investments within the portfolio will produce different returns. As a result, the portfolio will likely drift from its target asset allocation. Say it was 50% stocks, 50% bonds, it could drift to 55% stocks or 60% or more in stocks. In order to restore the portfolio's risk and return characteristics to what the individual is comfortable with, they would rebalance the portfolio. Meaning they would sell those asset classes that have outperformed, and they reinvest the proceeds into those assets that have underperformed.

[00:03:14] Say 7 out of 10 years stocks outperform bonds. In theory you would be selling stocks and reinvesting the proceeds into bonds. That's kind of what rebalancing is.

[00:03:24] The goal of rebalancing is to minimize risk relative to a target asset allocation. It's not maximizing returns. If an investor is looking to maximize returns, they would maybe not have bonds on the portfolio, right? They might allocate the portfolio 100% to equities. The reason why you add bonds in the portfolio is to help mitigate the downside risk on the equity side.

[00:03:48] I think the most important part is to figure out what asset allocation an investor can stick with in the best and worst of markets, and then through time rebalance or restore the asset allocation so that the portfolio doesn't become riskier than an investor's comfortable with.

[00:04:04] Jon: I'm going to make Frank a speaker to ask his question. 

[00:04:07] Frank (audience #1): What is the most efficient way of rebalancing: a time rebalance, meaning quarterly, semi-annually or annually, or a target rebalance.

[00:04:19] Colleen Jaconetti: We’ve actually done a lot of research on this. We looked at it if you did time only - monthly, quarterly, semi-annually, annually - or threshold only. So, say you deviate from that allocation by 1%, 5%, 10%. And what we found was there's no really clear advantage as far as maintaining the risk and return characteristics. The clearest advantage is when you compare those rebalanced portfolios to portfolios that were never rebalanced.

[00:04:42] I wouldn't say that there's one optimal way to look at it. What we have come to as a general guideline would be a combination of the two. To look at the portfolio on a semi-annual or annual basis and then rebalance the portfolio when it's 5% or more away from the target. The reason why is: there's cost to rebalancing. The most important thing is to factor in what those rebalancing costs could or would be, and then try to minimize those costs if you can.

[00:05:13] Jon: And that answered a related question from username ‘starboi’ from the Bogleheads® Forums, who asks how often should you rebalance. 

[00:05:19] Let's jump to another audience question. This one is from David. 

[00:05:23] David (audience #2): I have been looking at LifeStrategy Funds at Vanguard for a number of years. I was wondering if a LifeStrategy Fund that does rebalance over time, is it a given that you want to hold that in a tax-advantaged [account]?

[00:05:37] Colleen Jaconetti: When you're thinking about would you hold a LifeStrategy Fund in a taxable account or not, that comes down to asset location. For investors who are in higher tax brackets, it would be definitely preferred to hold a LifeStrategy Fund in a tax-advantaged account. So, tax-deferred or tax-free, because of the taxable bonds. 

[00:05:55] You could do it two different ways. From an asset location perspective, if you have sufficient assets, you could break up those allocations and not hold the LifeStrategy Fund. Hold the individual bond funds in tax-advantaged accounts and the equities in taxable accounts. 

[00:06:07] If you're in a high tax bracket and you want to hold a LifeStrategy Fund, I definitely would not hold that in a taxable account. Because there will be taxable bond income there that you could avoid by holding in tax-advantaged accounts.

[00:06:19] Jon: Colleen, as a follow up to that, with respect to holding those taxable balanced mutual funds in a taxable account, are capital gain distributions also an issue in the decision to hold a mutual fund in a taxable account? 

[00:06:32] Colleen Jaconetti: Yes, absolutely. So, it kind of depends on the type of equities you're holding out there. Bonds typically don't give off a lot of capital gains. Usually, capital gains would come from equities. If you're holding index equities, they are usually fairly tax-efficient. So, they do not give off a lot of gains. However, if they do give off gains, they would be more long-term capital gains.

[00:06:52] What you would want to specifically avoid in taxable accounts is investments that either give off a lot of long-term capital gains or significant short-term capital gains, because those short-term capital gains are taxed at ordinary income tax rates which can be twice as high as the capital gains rates. 

[00:07:09] If you're holding something like a Wellington Fund or a Wellesley Fund in a taxable account, you could keep an eye out on whether you're getting substantial capital gain distributions on the active piece. And if you are, then obviously holding those in a tax-advantaged account would likely be preferred. 

[00:07:26] Jon: This question is from username ‘GAAP’ from the Bogleheads® Forums who writes: “If you leave out all the touchy-feely stuff about comfort with risk and volatility, is there a benefit to rebalancing? Does it actually improve anything?”

[00:07:39] And a related question from username ‘er999’: “For the long-term investor with 20 years+ as their investment horizon is a bond allocation expected to improve returns or just reduce volatility?”

[00:07:52] Colleen Jaconetti: The primary purpose of bonds in a portfolio is to dampen the volatility of equities and help people maintain their asset allocation through time.

[00:08:02] If you are not worried about risk, and you're comfortable with the downside potential of equities, you wouldn't really need to invest in bonds. You're investing in bonds as a way to still make money or have a return on your portfolio without taking on the risk that you would be taking on in stocks.

[00:08:17] If your goal is to maximize returns, then most likely you would be 100% equity. If you would like some downside protection, especially when the stock markets are not doing well, usually bonds provides that ballast for the portfolio.

[00:08:31] Jon: I think implied in this question is that you've got a perhaps all-US stock portfolio and that ignores the consideration that, hey, if we're investing globally, we're going to have both US and international. And there could be an opportunity to rebalance between those two different types of stock funds.

[00:08:50] Colleen Jaconetti: Oh, absolutely. When we talk about rebalancing, and when we've done our tests on rebalancing, we usually don't have a threshold at the sub-asset class level - so between US and international. But if we did hit the 5% threshold, then we would take the allocations back to the original target.

[00:09:06] If you were targeting a 100% equity portfolio - 60% US and 40% international - certainly if your allocation to US got well beyond the 60% and you were not comfortable with that you could certainly pare it back.

[00:09:21] So it's certainly your preference whether you would want to go back or not, but it's definitely something that I would consider looking at maybe when you were 5% or more out of balance.

[00:09:30] Jon: I'm going to make John a speaker.

[00:09:33] John (audience #3): I read some research from Michael Kitces, and I think he says maybe even looking as often every week or every two weeks to see if anything has gotten out of balance. And then using that information to decide where to put more money. I just wanted to get your opinion on how often do you think people should look? 

[00:09:53] Colleen Jaconetti: If you have cash flow that you’re trying to put to work, that may be a case where you look at it more frequently. But we really didn't find a meaningful difference in risk or return whether we looked at it daily, monthly, quarterly, semi-annually or annually. I would say the things that would happen in those times - the more frequently you look at it - is an increase the number of rebalancing events which could also be an increase in some of the costs.

[00:10:18] And another thing I would think about when you're doing it a little bit too frequently is you don't want to be doing it in reaction to what's going with the markets. Sometimes it is hard when stocks are doing very well to rebalance out of stocks and then put it into bonds. Or sometimes when they're not doing very well, it's hard. It's really just trying to have a disciplined approach and follow that approach. 

[00:10:37] Weekly is a bit too frequent because it makes people be a little more prone to trying to time the market or try to guess which direction things are going. And as you know, these are clustered when the markets are doing well. And then when the markets are not doing well. There's been research around the main cluster, if you miss the 10 best days and/or the 10 worst days, it has a significant impact on the portfolio.

[00:11:00] I would say at the most frequent maybe monthly, but I really don't even think - we kind of recommend, semi-annually or annually - and then only if it's out of bounds by more than 5%.

[00:11:10] John (audience #3): And to that 5% point, if you have a lot of different asset classes, say that you have an asset class is only 5% of your portfolio, waiting until it's 5% out of balance would be pretty substantial. Either up or a complete loss. Do you dial that number based on the target size of the asset class?

[00:11:29] Colleen Jaconetti: What we end up doing is the 5% is at the stock and bond level. We don't really look at the underlying components. So, it's only when stock and bonds is off by five, then we take everything back to the targets. 

[00:11:39] Jon: And we've got Greg.

[00:11:43] Greg (audience #4): My question was about the behavior of long-term treasuries in market crashes. In some prior crashes, like 2008, the long-term treasuries were up around 20%. For the investor who wants to maximize their return with maximizing risk, is there any benefit to having some allocation to long-term treasuries? Or should 100% stocks be best if they want to try to maximize return with maximum risk?

[00:12:10] Colleen Jaconetti: I haven't looked at it whether an allocation of treasuries plus equities would provide a higher return than a 100% equity allocation. I would say treasuries have been a proven diversifier in times when the stock market is underperforming. Obviously, it's not going to provide the same amount of return over the long run as maybe equities would be. 

[00:12:32] We would generally have an allocation to total bond market. So, you would have corporates, treasuries, and mortgages. And then we would typically maintain the allocation of treasuries as that is the one area the market typically does well when the stock market's not doing well. 

[00:12:47] I would have to look into it a little more to be honest with you. If, you said, “Hey, would a 20% long treasury allocation combined with total stock and total international stock allocation outperform over the long-term?” I'm sure there would be shorter periods of time where it could outperform if the stock market's not doing well and treasuries are carrying a portfolio relative to a 100% stock portfolio. But I would have to assume that over long periods of time, the 100% equity portfolio would most likely outperform given what's happened in the past.

[00:13:14] Jon: We had Bill Bernstein on Episode #8 of the Bogleheads® Live show, and we talked about a related question to just this, "Hey, what is that ideal maturity treasury I want to be holding in my portfolio?" Dr. Bill Bernstein found in his research in the past, it's going to be somewhere between short and intermediate term depending upon how much in stocks you're going to have in your portfolio.

[00:13:39] I looked at something similar with more recent data and came to a similar conclusion. Short-term treasuries are what you want to have – generally, on average, historically - if you have a portfolio that's mostly bonds. But if you've got stocks, then in your intermediate-term treasuries are what you want to consider. It's harder to make a case for those long-term treasuries.

[00:13:58] For the Certified Financial Planners in the audience, they can check out the XY Planning Network’s CE presentation that I gave – “Which Bonds are Best?” - that talks a little bit about that.

[00:14:10] Colleen Jaconetti, any final thoughts on rebalancing before I let you go?

[00:14:17] Colleen Jaconetti: You don't always have to rebalance back to the target asset allocation. It really depends primarily on rebalancing costs. So, when the costs are mainly fixed and independent of the size of the trade - say the cost of time - rebalancing to the target allocation is probably optimal because it reduces the need for further transactions.

[00:14:34] But on the other hand, if trading costs are mainly proportional to the size of the trade, say commissions or taxes, rebalancing to the closest rebalancing boundary might be preferred.

[00:14:42] So, if your 50/50 went to 58, you might want to only rebalance back to 55 if there's substantial costs such as taxes or commissions. If you have both types of costs, then you might want to rebalance to an intermediate point. I just think it's important that you don't always have to go back to the target if it would be very costly. Our research also showed that that would be just as preferential. 

[00:15:02] Rebalancing is really to reduce risk as opposed to maximizing return. And over long periods of time, we've found it helps people stay invested.

[00:15:12] Jon: Thank you again so much for joining us. Really appreciate your insight and your wisdom today.

[00:15:16] Colleen Jaconetti: Thank you. I enjoyed it. 

[00:15:17] Jon: That's all the time we have for today. Thank you to Colleen Jaconetti for joining us today, and thank you for everyone who joined us for today's Bogleheads® Live. 

[00:15:24] For the next Bogleheads® Live, Cameron Huddleston, award-winning journalist and author of, “Mom and Dad, We Need to Talk: How to Have Essential Conversations with your Parents About their Finances.” 

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[00:15:58] Thank you again, everyone. Look forward to seeing you all again next time. Until then, have a great one.