Rebalancing, according to Wikipedia, is “the action of bringing a portfolio of investments that has deviated away from one’s target asset allocation back into line.” How to do that optimally is the subject of this post. Below is a sample allocation to facilitate the following discussion of rebalancing. It should not be construed as a recommended portfolio in any way.

Asset Class	Target Allocation
U.S. Large Stocks	20%
U.S. Small Stocks	10%
Foreign Stocks	10%
REITS	10%
High Yield Bonds	10%
Investment Grade Fixed Income	40%

 

 

Following are the factors involved in rebalancing (in no particular order):

• Due to the momentum that exists in the markets, rebalancing should be done slightly less frequently than it would be otherwise. Allowing an asset class that has grown (decreased) through good (poor) performance to remain overweight (underweight) can add value. Even if momentum effects don’t add value net of costs as a trading strategy, not rebalancing is costless. Academic research has indicated that if rebalancing mechanically on a time schedule (monthly, quarterly, etc.) the optimal period is probably between one and two years.

• If cash flows are expected soon, it may be prudent to delay rebalancing. If a deposit into the portfolio is expected, those funds can be used to perform the rebalancing with trades that would have to be done anyway to invest those funds. Similarly, if cash will need to be distributed from the account soon but not immediately, it may be prudent to wait until that trade is required and use it to perform, at least to some extent, the rebalancing.

• If it is a taxable account, the recognition of capital gains should slow rebalancing while the recognition of losses should speed it. Note that I am not advocating that taxes should drive the asset allocation, but merely that at the margin, taxes should have some impact on whether and when an asset class is brought back into balance. Waiting until a holding becomes a long-term capital gain will almost always be appropriate. Also, in a taxable account where the owner’s life expectancy is not long, allowing asset classes that have grown “too large” to remain that way to capture a step-up in basis at death may be prudent. The trade-off between a “sure” gain (if anything in the tax code can be considered a sure thing) of 23.8% (or even more if there are state taxes) of the gains vs. slightly higher risk from not rebalancing must be weighed.

• The transaction costs are important as well. Generally this involves not just the commissions, but also the costs from overcoming the bid/ask spread and the market impact costs. These can be particularly large when the security is illiquid. Obviously, the lower the transaction costs, the more frequently rebalancing should occur.

• The magnitude of the discrepancy is a factor as well. For example, an asset class that is 10 basis points (0.10%) out of balance is almost certainly not worth “fixing.” On the other hand, one that is 1,000 basis points (10.00%) out of balance almost certainly is.

• The correlation of the asset classes that are out of balance matter as well. For example, suppose U.S. Large Stocks have grown to be 25% of our allocation, at the expense of Investment Grade Fixed Income which is now at 35% (versus the target allocation specified earlier). Given the dramatic differences between those two asset classes, rebalancing may well be prudent. Conversely, if U.S. Large Stocks have grown to be 25% at the expense of U.S. Small Stocks at 5%, the correlations and risk/return profiles are so similar that “fixing” it may be unnecessary.

• The size of the portfolio matters as well. If the U.S. Large has increased to 22% while the Investment Grade Fixed Income has decreased to 38%, that may or may not be worth fixing. If the total portfolio is valued at $100,000, the amount of the rebalancing trade is a mere $2,000 – probably not worth the transaction costs. On the other hand, if the portfolio is worth $10,000,000, the trade would be $200,000 which might make sense.

• If there is a better investment option available, rebalancing may be more attractive. Suppose our allocation to Investment Grade Fixed Income is slightly high with U.S. Large Stocks being low, but it hasn’t risen to the level that would normally trigger a trade. However, we have a slight preference for a different fixed income investment but not enough to warrant a trade. In conjunction with a slightly out-of-balance portfolio though it might make sense, fixing the out-of-balance condition would be two trades. Changing the fixed income allocation would also normally be two trades. But if we do both simultaneously it is only three trades: sell all the current fixed income and buy stocks and the replacement fixed income vehicle.

• The number of asset classes to fix will affect the decision to rebalance as well. For example, suppose that U.S. Large has 24% while U.S. Small has 6%. Doing two trades to fix that may make sense (depending on all the other factors we have discussed). But if U.S. Large Stocks has 24% while U.S. Small Stocks, International Stocks, High Yield bonds, and REITS each are at 9%, the number of transactions – and thus the transaction costs – may make it imprudent.

• The sensitivity of clients to trades may impact the decision as well. Clients in fee-based accounts are probably relatively insensitive to an additional trade, while a client in a commission-based account may be suspicious that the trade was done purely to generate another commission. This is a problem, and may lead to too little rebalancing in commission-based accounts to reduce this perception of over-trading (even if there isn’t any). So, oddly, a commission-based account can lead to too little trading from an objective standpoint, but it may still be optimal to maximize client happiness.

• Academic research in the field of behavioral finance shows humans in general, and men and professionals in particular, have a propensity to over-trade. This is probably related to over-confidence and a need to “do-something” even if it isn’t particularly helpful (see Congress for example). When in doubt, don’t trade is probably a good rule.

The complexity and inter-relatedness of these factors is why we don’t use an automated system to rebalance our client portfolios. Rather, at least quarterly, we review and evaluate all the portfolios manually in light of the above factors to determine what trades, if any, should be made.

I try (I really do) not to be the grammar police, but there are three terms routinely – and improperly – used by financial professionals. I can’t sit idly by when even Warren Buffet (who I greatly respect) is getting it wrong. Now, after you read this, in at least one aspect you can be smarter than Warren.

I think the reason some terms are used at all is that investment professionals try to adopt the veneer of the hard sciences to gain credibility, but it doesn’t help much when the appropriated terms aren’t even used correctly!

Our first term is Negative Feedback Loop. A negative feedback loop dampens itself. A positive feedback loop increases in magnitude because it feeds on itself. For example, as we saw in the mid-2000’s people bought houses causing prices to increase, causing people to want to buy houses to get in on the deal, causing prices to increase, etc. A negative feedback loop would be something like a thermostat. A temperature decrease closes the circuit in the thermostat causing the heat to come on and increase the temperature until the circuit opens again. This keeps the temperature at a relatively constant level. The 2008 Berkshire letter to shareholders is a good example of the misuse of this term:

By the fourth quarter, the credit crisis, coupled with tumbling home and stock prices, had produced a paralyzing fear that engulfed the country. A freefall in business activity ensued, accelerating at a pace that I have never before witnessed. The U.S. – and much of the world – became trapped in a vicious negative-feedback cycle. Fear led to business contraction, and that in turn led to even greater fear.

The situation described is a positive feedback loop (or cycle) in a negative direction which is not at all the same thing as a negative feedback loop.

Reversion to the Mean is a second term often used incorrectly. Reversion to the mean is properly used to indicate that extreme occurrences are followed by less extreme occurrences. For example, suppose a husband and wife are each five inches taller than average. Their children will also be taller than average but not five inches taller than average. Their heights will tend to “revert” toward the population mean. If this were not true, people would routinely be ten feet tall after a few generations of the tall folks breeding. In the context of the market, when people say “reversion to the mean” they don’t generally mean because the market was up so much (say 20%) it will be above average again but not quite as much (say 15%), they mean it will be below average (like minus 10%) so that the average approaches the prior mean. The proper term for this is negative serial correlation not reversion to the mean.

The third term is Liquidity. Marketability means you can buy or sell something. Liquidity means the act of buying or selling quickly won’t change the price much. I have heard advisors say stocks aren’t liquid because they can go down in value, or you should keep five years of living expenses in cash for liquidity. Substantially all of most people’s portfolios are extremely liquid. All open-end mutual funds and all investments with trading volumes many times the size of the position you are trying to trade are extremely liquid. What people mean to say is that some investments are volatile (to which the appropriate response should be, “well, duh”). Volatility and liquidity are not the same thing, though illiquid investments are frequently volatile; volatile investments can be very liquid.

Finally, a bonus oddity – International. The investment industry for some inexplicable reason uses the term “international” when they mean “foreign” and are then are forced to use “global” when they mean “international.”

I now relinquish the post of grammarian…

What spending order is optimal for a retiree who is older than 59½ having three types of accounts: a taxable account, a Roth IRA, and a traditional IRA with no basis?

The default order is:

1. Taxable (preserves tax deferral in the other accounts)
2. IRA (no RMDs on the Roth, so this reduces future RMDs by taking the funds now)
3. Roth

In other words, the taxable account should be exhausted before drawing down the IRA which in turn should be exhausted before drawing upon the Roth. There are exceptions to the default order however:

1. To the extent the assets in the taxable account have a low basis and/or the owner’s life expectancy is short, it may be prudent to leave the assets untouched for a step-up in basis rather than sell them to live on.

2. After the taxable account is exhausted, if the tax bracket is abnormally high it may make sense to spend Roth funds ahead of IRA funds (or find some other way to get to next year and a more normal tax bracket such as tapping a HELOC temporarily).

Contrary to popular belief, if the tax bracket is abnormally low (or there is “room” in a moderate bracket) it is not optimal to withdraw extra funds.  Rather, (partial) Roth conversions to use those low brackets are a superior strategy.  (See this post for more on the analysis of Roth vs. IRA in general.)

The reason the Roth is last in the list is simply because, under current tax law, there are no RMDs on Roth IRAs (there are on Roth 401(k) accounts).  If all retirement accounts had RMDs (or no RMDs) they would all be equivalent (see this post for caveats though).

The real goal is to preserve tax deferral as long as possible (without triggering higher tax rates), so with that in mind, we can add a little complexity to the simple order above, this is a more complete ordering for a married couple who may also have inherited IRAs:

1. Taxable
2. IRA or Roth inherited by older spouse
3. IRA or Roth inherited by younger spouse
4. Older Spouse’s IRA
5. Younger Spouse’s IRA
6. Roth

This order assumes the spouses have similar ages.  It is possible that given a large enough age disparity options 3 & 4 could swap places temporarily.

What is the optimal mortgage an investor should have on their home? Should investments be liquidated to reduce the mortgage? Or, should the mortgage kept or even increased in order to increase the investment portfolio?

Though these are common straightforward questions, the answers provided are often simplistic and incorrect. I would like to discuss this in four parts. First, I will clarify the questions and address some common misconceptions. Second, I will address the analytical and rational analyses needed. Third, I will examine some emotional and behavioral constraints. Fourth, I’ll attempt to summarize, and make a few other observations.

Clarifying the Question. Whether considering immediately paying off a million-dollar mortgage from a portfolio or simply adding an extra $100 per month to the mortgage payment, the issue is the same. In both cases, the funds could either be invested or be used to reduce the mortgage, in effect “earning” the applicable interest rate. The easy answer here is, “Keep your mortgage; you’ll get a higher return on a larger portfolio.” Is the easy answer, however, the best for the investor? Each situation should be analyzed individually to determine the best solution.

(Note that, unless defaulting is a possibility, we are not addressing real estate exposure. The actual exposure to real estate is identical in both cases, and this decision merely affects the financing. To clarify, imagine that instead of having a mortgage, you have a debt identical in every way but unsecured – the real estate exposure is unchanged.)

Analyzing the Payoff. At its root, the question involves the asset allocation. Reducing the mortgage is effectively the same as purchasing bonds (technically it is a reduction in a short bond position). Conversely, taking out or increasing a mortgage is, in effect, issuing bonds. If the overall asset allocation already includes exposure to fixed income (as almost every portfolio does), what is the optimal way to determine that allocation?

Suppose a family has a portfolio of $1 million allocated 60/40 to stocks and bonds, along with a $200,000 mortgage. They thus have $600,000 exposed to equities. But while they are $400,000 long in fixed income, they are also $200,000 short in fixed income via the mortgage, for a net of $200,000. So, although the investment portfolio has a 60/40 mix, the allocation is actually 75/25 when looked at from a broader perspective.

Worse, people are typically paying on the spread. The long rate (bonds) is lower than the short rate (mortgage). When most people pay off the mortgage, what they really do is adopt a more conservative asset allocation.

When determining whether to pay off the mortgage, it’s important to keep the desired aggregate asset allocation unchanged. The asset allocation should have been determined earlier in the planning process using a Monte Carlo simulation or similar analysis. In addition, the comparison should be with the rate of return on Treasury bonds with similar duration.

This calculation may seem strange at first. But remember that a mortgage, although risky to the issuer, is actually a risk-free opportunity for the investor. If the investor pays off the mortgage, they are guaranteed to save the interest that they would have paid. Also, the duration of the mortgage is shorter than the duration of a bond with the same maturity, since a portion of each payment is principal in the case of the mortgage. For simplicity, the yield on a 10-year Treasury will generally be close enough in duration to a 30-year mortgage for comparison.

Tax considerations, because they tend to be the same for both alternatives, are not relevant. If an individual has a mortgage at 6% and is in the 25% tax bracket (ignoring any state income taxes), the after-tax cost is 4.5%. Alternatively, in purchasing a bond yielding 6%, the after-tax return is also 4.5%.

Other tax-related factors might favor paying off the mortgage, however. These include the impact of state income taxes and whether the taxpayer itemizes on their tax return (or is over the standard deduction by less than the mortgage interest).

In other words, if the gross rate of return on the fixed-income investment is lower than the interest rate on the mortgage (almost always the case), no further analysis is needed. If the fixed-income gross yield is lower but close, more detailed analysis may be necessary.

Looking at the Psychological Factors. The emotional implications of the mortgage-payoff decision are equally important. How an individual feels about having a mortgage is significant, yet more difficult to quantify. Many people are happy to be debt-free. Yet they should consider at least three other issues before tearing up the mortgage.

Perceived volatility. If an investor pays off the mortgage yet keeps their global asset allocation unchanged (reducing fixed-income exposure by the same amount as the mortgage payoff), the portfolio will appear more risky even though the total risk has not changed. This is a big problem; at a minimum, the investor should understand that their finances will look substantially more volatile than they really are.

Going back to our earlier example, the person with a 60/40 portfolio now has a 75/25 portfolio though the aggregate asset allocation has not changed. Since investment portfolios (but not mortgages) are “marked to market,” the position may feel more precarious. For people who anxiously examine every monthly statement, this shift could be an important factor in the payoff decision. It will be less important for more financially sophisticated people who understand the situation and have a long-term view.

Ability to stay with the target allocation. Some people will react to the increased portfolio volatility by panicking in poor equity markets and improperly reducing their exposure to stocks. Others, however, may feel more secure knowing that, no matter what happens, they have their home paid for and will be more willing and able to tolerate volatility and an appropriate equity exposure.

Propensity to save. Since most people in this country don’t save enough, paying off a mortgage can be problematic. People may feel poorer after reducing their portfolios to pay off the mortgage, and so they should be motivated to save to get their portfolio back to where it was. Yet behavioral finance has shown the reverse to be true; as people have more wealth, they are more motivated to save.

More significant is the fact that an individual without a mortgage must still save the amount of the mortgage payment to remain in the same financial position. In a way, a mortgage is a type of forced savings plan. If the person simply spends the monthly amount that was previously being spent on the mortgage, they have effectively reduced their savings rate. For example, in one real-life case, while the investor understands this analysis perfectly, he prefers to keep a relatively large mortgage to restrain household spending.

Proposing an Answer (and some other considerations). First, many investment advisers and planners have a conflict of interest in giving advice on this issue and should fully disclose that conflict. Advisers, whether they receive commissions on investment transactions or fees for assets under management, will reduce their compensation by recommending the mortgage be paid off from the assets in the portfolio. The reduction in fees, however, in my opinion is eliminated in the long run as the adviser gains a reputation for doing the right thing regardless of the personal cost thereby garnering more than enough business to compensate for losing managed assets initially.

Second, investors should almost never take funds from tax-advantaged accounts to pay off the mortgage. They should also maximize their contributions to these accounts before increasing their mortgage payments to pay down principal.

Third, in the case of a minister who needs housing expenses to preserve the tax-free treatment of his housing allowance, a mortgage may be preferred.

Fourth, an individual with a great deal of inflation risk (such as a retiree with a very large pension that has no COLA) may be well-served by a long-term, fixed-rate mortgage to function as an inflation hedge.

To recap, the traditional advice to keep the mortgage and collect a higher return from the portfolio is too simplistic; it compares a risk-free return with a risky return. Reducing the portfolio by paying off the mortgage is usually the correct answer from a logical standpoint because the rate of return on the mortgage is frequently (though not always) higher than the equivalent fixed-income investment opportunity.

Retirement spending rates are very important. Even for those not yet retired, this report should be useful because it indicates how to set an appropriate goal to enable comfortable retirement.

We generally try to use the phrase “achieve financial independence” rather than “retirement” since some folks don’t plan to retire; but, for the purposes of this paper, we’ll say retirement because we are talking about potentially spending down a portfolio which implies actual cessation of work.

When working with clients, we are actually trying to maximize happiness given an uncertain future. To compare retirement spending strategies, we use a mathematical technique known as Monte Carlo Simulation (MCS), which is used when attempting to model something with high levels of uncertainty (such as the future returns on financial instruments). A successful plan doesn’t run out of money and yet allows the maximum spending possible. (As many people have observed, optimal financial planning would have your check to the undertaker bounce.) These two objectives are obviously opposed to each other, and, to complicate it further, few people know how long the funds need to last (i.e. they don’t know their date of death in advance). MCS can help us analyze the probabilities of various outcomes. As the comedian Henny Youngman observed, “I have all the money I need provided I die by 4 o’clock this afternoon.” How much do we need?

Let me give the general conclusion first and then mention some items that may influence the conclusion. Many studies have been done on what are called “sustainable withdrawal rates” from a portfolio given a number of parameters. We have replicated the research and are comfortable with the conclusions. First, there are assumptions about the future returns and volatility of the portfolio. Sometimes purely historical figures are used; sometimes expectations of the future are used. Second, there are assumptions about what the spending pattern will be. Generally, not only are people uncomfortable with their spending having to potentially decrease; they would actually like it to increase over time to keep up with inflation. Third, people would like a high probability (85-90% chance) of not running out of money.

Let me talk about that last point for a moment. The reason you don’t seek a 100% success rate is that it leads to plans that are so conservative you could maintain your spending rate through two consecutive market crashes and great depressions, but wouldn’t get to enjoy yourself much in all the other situations. Remember, the goal is to maximize happiness by steering a middle course between 1) not running out of money and 2) enjoying your accumulated wealth (by spending it rather than merely looking at it or counting it).

Using those assumptions, for a typical person entering retirement (typical age, life expectancy, reasonable investment portfolio, etc.), the sustainable withdrawal rate is approximately 4%. In other words, if you desire $40,000 each year from your portfolio (in addition to Social Security and any pensions), you need a $1,000,000 portfolio. If you want $100,000 each year from your portfolio, you need $2,500,000. A simple way to compute this figure is to multiply your desired spending from the portfolio by 25 to get the nest egg needed. Alternatively, as you approach retirement, you can divide your portfolio by 25 to see what your initial spending might be.

Caveats and other points:

1. The figures mentioned previously are gross of taxes. In other words, the figures should be reduced by the taxes. If you are in a 25% marginal tax bracket and the funds are coming out of a traditional IRA or 401k, you would only net 3% from a withdrawal of 4%. If the funds are coming out of a Roth IRA, no reduction is necessary since the proceeds are tax free.

2. Many people with relatively modest lifestyles needs may have much of their need covered by Social Security. On the other hand, for younger people, it may be wise to discount the possibility of Social Security. Also, Social Security is very regressive and will replace a much higher proportion of a lower income than it does a higher income.

3. Some retiree costs, particularly healthcare, generally increase at rates higher than the overall inflation rate. On the other hand, many retirees gradually reduce their consumption (of items other than healthcare) as they age. One wag has termed this the three stages of retirement: go-go, slow-go, and no-go. To the extent a retiree does not have good health coverage (for long-term care for example) they may want to reduce their withdrawal rate slightly to have more available for that contingency.

4. The figures above are for someone beginning retirement at normal retirement age. Obviously someone who is 90 years old could consume much more than 4% of his or her portfolio each year with relative safely.

5. In the 10-15% of cases where the projection indicates running out of funds, the retiree shouldn’t literally run out. The problem should be evident early and lead the retiree to take action before actually depleting all of their resources. The cases where failure of the plan occurs are generally where very poor returns happen right at the beginning of retirement (someone retiring at the end of 1999 or 2006 for example). The options at that point would include 1) reducing spending (downsizing possibly), 2) generating more income (part-time job for example), or 3) a reverse mortgage (to tap home equity). This last option is why our retired clients generally have no debt. It leaves the home equity as an emergency back-up in extreme situations.

6. In many cases, spending can increase in later years by more than the initial plan indicated if portfolio returns have been good. This methodology in essence provides for all but the bottom 10-15% of cases working out. If, in fact, the retiree is simply in the middle case (the 50th percentile), they are in very good shape.

One final note: While many people have “don’t spend principal” as a rule of thumb, it isn’t the best way to look at your portfolio for three reasons:

1. It ignores the effects of inflation over time. If inflation is 10% and interest rates are 12%, spending just the 12% “interest” will deplete the purchasing power by 10% per year.

2. It can lead to poor investment decisions as high-yielding investments are selected over investments that might be safer or have a higher return but through growth rather than yield. Many individuals have bought bonds trading at a premium or extremely poor quality investments due to the high current yield. Buying exclusively high yielding investments will also increase exposure to interest rate risk.

3. For younger retirees, focusing on maintaining the real (inflation adjusted) value of the portfolio would make sense, but for someone older the portfolio can decline somewhat in value without serious risk. For example, imagine a 90-year-old with a $1,000,000 portfolio. He or she could spend $50,000 per year of the principle and it wouldn’t run out until age 110.

In conclusion, most people should plan to spend 4% (gross) of their initial portfolio balance in retirement and increase that slightly every year to keep up with inflation. About 10-15% of the time, an adjustment of some sort will be necessary, but the other 85-90% of the time the plan should work out just fine.