Here’s a slightly updated and revised version of an older post I had on rebalancing a portfolio to maintain a target asset allocation.

What is Rebalancing?
Let say you examine your risk tolerance and decide to invest in a mixture of 70% stocks and 30% bonds. As the years go by, your portfolio will drift one way or another. You may drop down to 60% stocks or rise up to 90% stocks. The act of rebalancing involves selling or buying shares in order to return to your initial stock/bond ratio of 70%/30%.

Why Rebalance?
Rebalancing is a way to maintain the risk to expected-reward ratio that you have chosen for your investments. In the example above, doing nothing may leave you with a 90% stock/10% bond portfolio, which is much more aggressive than your initial 70%/30% stock/bond mix.

In addition, rebalancing also forces you to buy temporarily under-performing assets and sell over-performing assets (buy low, sell high). This is the exact opposite behavior of what is shown by many investors, which is to buy in when something is hot and over-performing, only to sell when the same investment becomes out of style (buy high, sell low).

However, in taxable accounts, rebalancing will create capital gains/losses and therefore tax consequences. In some brokerage accounts, rebalancing will incur commission costs or trading fees. This is why, if possible, it is a good idea to redirect any new investment deposits in order to try and maintain your target ratios.

How Often Should I Rebalance?
[Read more…]

The term “Safe Withdrawal Rate” (SWR) usually refers to the amount of your portfolio that you can withdraw each year in retirement safely without running out of money. The “4% rule” is often used, which says that if you want $40,000 inflation-adjusted every year safely , you need $1 million as your target.

Reader Dave thoughtfully sent me an interesting Financial Advisor magazine article about an upcoming academic paper by Dr. Wade Pfau that takes a look at this from another angle. What if you wanted to figure out a “Safe Savings Rate”?

Let’s say you save for 30 years, and then retire (spend) for 30 years. The traditional SWR only depends on the 30-year period when you are saving reach that target number. Instead, what if you looked at the entire 60 year period together. This ends up smoothing things out, because periods of high return are often followed by periods of low return, and vice versa.

Here are the baseline assumptions. The goal is to withdraw 50% of current salary, inflation-adjusted, during retirement. You maintain a constant asset allocation of 60% stocks and 40% bonds (T-Bills). Results are in the chart below. The blue line is the saving rate according to the 4% rule, and the black line is based on the new 60-year test period using actual investment returns.

Based on market data since 1871, a savings rate of 16.62% would have worked every time. As you can see the black line is also much more consistent over time. Can everyone manage that? Maybe not, but few people are satisfying the 4% rule as well.

The given scenario is not one-size-fits-all, but it would be interesting if this research was expanded into some sort of retirement calculator. For example, all other things held the same, if you saved for 40 years, the safe saving rate drops to 8.77%. If you saved for only 20 years, the safe saving rate rises to over 30%. I’ll have to wait for the published paper to see what happens if you go a bit riskier into say 80% stocks/20% bonds, or if it accounts for changing allocations over time.

Update: Here is a link to the working paper [PDF].

If you have a 401(k), 403(b), or similar retirement plan, you may have an investment option called a stable value fund. Sometimes it goes by a different name like Guaranteed Pooled Fund, but they are always marked as a conservative investment. The pitch is basically the higher interest rate of longer-term bonds, with the relatively liquidity and stable principal value of a money market fund. I explored the risks and rewards of stable value funds before and currently hold them as part of my bond allocation.

My specific stable value fund is run by Transamerica Financial Life Insurance Company (TFLIC) and offered an interest rate of 3.5% for all of 2010, which was much higher interest than any other similar bond investment was going to pay me. Then they told me that until February 28th, 2011, the interest rate would be 3.0%. Finally, I just received a letter that told me that the interest rate from March 1st to December 31st, 2011 would be lowered to 1.8%.

So, should I stay or should I go? Interest rates continued to drop in 2010, so I did expect them to lower their rate.

Online savings accounts like Capital One Consumer Bank are paying around a low 0.75% APY, and I have no access to something like that in my 401k. They recently announced a self-directed option through Schwab, although I need to find more details about how much transaction costs would be. The Vanguard Short-Term Treasury Fund (VFISX) is currently yielding only 0.66%. Taking a look at current Treasury yields shows the 2-year at 0.78% and the 5-year at 2.30%.

So the interest rate itself is still pretty competitive relative to other “safe’ investment options. My other bond alternative inside the account is the huge PIMCO Total Return fund (PTTRX) with a 3.12% yield and 4.8 year duration, which did pretty well for me when I had it but I worry about asset bloat with $240 billion is assets, manager risk, and interest rate risk.

In the absence of any significantly better options, it looks like I’m staying put.

In my last post, reader Greg shared a better chart that illustrates the components of the Consumer Price Index, which is supposedly to track what the average consumer spends and thus is used to gauge inflation. Definitely worth archiving for later.

Source: New York Times. Click to visit. It’s interactive, so you can zoom in and out to see all the little details.

The January 2010 issue of SmartMoney magazine had a nice little article Target-Date Funds Retool — Again about how those all-in-one Target Retirement funds that nearly all 401k plans have now are almost all increasing the percentage of stocks that are international. They all say this not performance-chasing, but at the very least it’s sentiment-chasing. People just aren’t all that confident in an predominantly-US portfolio anymore. I like the quote “Were you wrong before, or are you wrong now?”.

In any case, the online version left out my favorite part of the handy graphic, so I scanned it in here:

Vanguard announced back in October that it was also following the herd and increasing international exposure for its funds, and a quick look on the Vanguard Target 2025 fund shows the international holding at 20.8% as of 12/31/10. Seems like they are rolling out the change gradually.

I’m always on the fence on these funds. If having one fund keeps people from jumping from one fund to another, these funds can be a net positive. I like simplicity. But you have to watch out for high costs because that will eat away at your return. On the other hand, you can construct your own retirement portfolio out of just a few funds now, and not have to watch these guys follow each other around. Even the Vanguard Target 2025 fund only has 3 funds inside of it.