Quizmaster, Doug Hutchinson has come up with another great quiz that compares buy-and-hold versus account rebalancing. Let’s see what the math has to say. Good luck!
Consider this scenario:
An investor has a $100,000 portfolio that is 60% stocks and 40% cash
In Time Period 1, the stocks in the portfolio decline by 10%
In Time Period 2, the stocks in the portfolio increase by 11%
For this particular scenario, would the investor have been better off with a buy-and-hold strategy (no trading in Time Periods 1 or 2) or a rebalancing strategy that rebalanced back to target weights (60% stocks/40% cash) at the end of Time Period 1?
Solution:
Buy-and-Hold Strategy:
In Time Period 1 the stocks in the portfolio decline by 10%: ($60,000 x (1 - 0.1) = $54,000
The value of the cash in the portfolio doesn't change ($40,000)
so the total value of the portfolio at the end of Time Period 1 = $54,000 + $40,000 = $94,000
In Time Period 2 the stocks in the portfolio increase by 11%: ($54,000 x (1 + .11) = $59,940
the value of the cash in the portfolio doesn't change ($40,000)
so the total value of the portfolio at the end of Time Period 2 = $59,940 + $40,000 = $99,940
Rebalancing Strategy:
In Time Period 1, the stocks in the portfolio decline by 10%: $60,000 x (1 - 0.1) = $54,000
The value of the cash in the portfolio doesn't change ($40,000) so, the total value of the portfolio at the end of Time Period 1 = $54,000 + $40,000 = $94,000
Now, at the end of Time Period 1, the investor will rebalance the portfolio back to target weights. With the decline in the market, stocks now represent less than the 60% stock target ($54,000 / $94,000 = ~57.45%). The investor will need to use cash to purchase stock. To determine the correct amount of cash to use, the investor will need to solve this equation: ($54,000 + x) / $94,000 = 0.60. Solving this equation for x, the investor determines that he needs to purchase $2,400 worth of stock to restore the equity level to 60%.
After the purchase, the portfolio will now hold $56,400 ($54,000 + $2,400 = $56,400) worth of stocks and $37,600 ($40,000 - $2,400 = $37,600) worth of cash.
In Time Period 2, the stocks in the portfolio increase by 11%: $56,400 x (1 + .11) = $62,604 The value of the cash in the portfolio is still $37,600 so, the total of value of the portfolio at the end of Time Period 2 = $62,604 +$37,600 = $100,204.
In this particular scenario, the rebalancing strategy resulted in a higher ending value ($100,204) than the buy-and-hold strategy ($99,940)
In other scenarios, a buy-and-hold strategy will outperform a rebalancing strategy. The performance of each type of strategy is dependent on market conditions.
Ask your wealth manager to “do the math” when recommending either scenario.
Our Investment Policy Committee considers scenarios like this and others as we formulate recommendations. If your scenario is similar to the one above and you have questions, please call us at 1-800-541-7774 or contact us here. We are happy to help you analyze your unique investment scenarios.
