Horseshoes and Hand Grenades
- Joshua M Brown
- June 8th, 2014
“Have no fear of perfection, you’ll never reach it.”
- Salvador Dali
Whoever sold you on the idea that precision or perfection were necessary in investing was probably selling you something else entirely. Because anyone who’s spent enough time in the industry knows that a) precision doesn’t exist in a biological system like a market, only in a mechanical system and b) even the best managers know better than to get caught up in a grail quest for the ideal.
When investing toward a goal that’s somewhere between ten and thirty years out, it’s nice to have metrics telling you you’re on track along the way, but it’s dangerous to obsess over those metrics and allow them to lead you toward irrational behavior when they don’t say what you want them to.
In my practice, anytime we’re updating a client on a financial plan and can tell them they’re above an 80% statistical likelihood of hitting their stated objectives, we’re happy. Clients with certain personality types may wish they were hearing 85% or 90%, of course – which is totally understandable – but it’s our job to help them get past that sometimes.
In portfolio management, the same desire for perfection can quickly add unnecessary complexity to an already complex undertaking if we’re not careful. In today’s world of near-unlimited investment choice in the marketplace, quantitative software at our fingertips and exponentially more analytic horsepower, the temptation to twist the dials and tweak the knobs is more seductive than ever. Again, it becomes important to remind ourselves that every decision, even a decision not to make a decision, could have unexpected consequences – on costs, performance, volatility or all three. Therefore, decisions to do something ought to require a great deal more weight behind them than decisions to abstain from action.
We’re blessed to have a highly educated, highly engaged clientele and many of the households we serve come from the technology and engineering fields. One of the more frequent questions we get is about the actions we do take with respect to rebalancing our asset allocation strategies. We’re often asked about how we decide on the timing, threshold, tax consequences, transactional costs and other considerations around our systematic process. These are all great questions and we always strive for transparency when explaining our rebalancing optimization techniques and procedures. The truth is, the term optimized is perfection‘s first cousin. Unfortunately, there’s no such thing as either in actual practice – there is only ever going to be “close enough.”
Engineers hate “close enough” but they gradually become more comfortable with the concept when we walk them through all of the variables (and the variability of variables) that prevent the sort of precision in the realm of capital markets they’ve been trained to seek out elsewhere.
Those desperate for precision are guaranteed to be disappointed.
But don’t get frustrated yet – I’ve got good news for you…
It turns out that a perfectly optimized rebalancing process is absolutely unnecessary for long-term success. Thanks to research from Vanguard into the most popular rebalancing methods in use today, we know that the existence of a plan is paramount to the actual tactics within the plan – so long as there’s consistency throughout. What trumps the rebalance methodology itself is the mere fact that someone sticks to a rebalance plan, period.
Here’s Vanguard’s Fran Kinniry explaining the importance of constancy over exactitude:
Our 2010 study looked at the performance of portfolios that used rebalancing strategies based on various time intervals, allocation thresholds, and combinations of both. The time-based portfolios were rebalanced monthly, quarterly, or annually, while the threshold categories were rebalanced when allocations deviated by a predetermined minimum (in this case 1%, 5%, or 10%) from their target allocations. The “time-and-threshold” strategy combined periodic monitoring with predetermined minimum rebalancing thresholds.
Which strategy worked best? We found that no one approach produced significantly superior results over another. However, all strategies resulted in more favorable risk-adjusted portfolio returns when compared with returns for portfolios that were never rebalanced.
Whether the decision is to rebalance on a periodic basis or when allocations hit a certain threshold, or a combination of both methods, the key is to stick to the strategy, not to rebalance in response to market events. Furthermore, portfolio monitoring for the purpose of rebalancing should be done on a specific anniversary date.
Josh here – as you can see from the above table, virtually all of the portfolios ended up in the same place eighty-three years later, with some minor differences in volatility, turnover ratios and trading events.
Now of course, in real life nobody has an eighty year time horizon except endowments, foundations and other institutions that are meant to grow capital in perpetuity. That said, there are merits to each of these approaches for a regular person with a normal time horizon who is seeking to avoid being caught up in asset bubbles. Rebalancing – as opposed to market timing – is the most rational way to accomplish this.
But rebalance how?
As you can see above, the right approach to rebalancing may make a difference, but probably not a huge one given enough time. What’s more important is the act itself – and the commitment to carrying it out regardless of what the chimpanzees are screaming about each day in the headlines.
My suggestion for those striving for perfection is to do so outside of the investing arena. As with horseshoes and hand grenades, in planning and portfolio management, close enough is probably going to do the trick.
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The Reformed Broker is a blog about financial markets and the economy. Joshua Brown is a New York City-based investment advisor for high net worth individuals, charitable foundations, retirement plans and corporations... More.