Bob French, CFA

On the Power of Disciplined Investing

roller coasterThe markets have been doing really well for a really long time. They’ve just kept going up since the global financial crisis in 2009 – aside from the usual short-term blips (which have gotten pretty blippy at times). But what goes up must come down, and a lot of people are starting to think this bull market is looking a little less buoyant.

And they want to do something about it.

Now, I have no idea what the markets are going to do (if I did, I’d be sitting on my private island and not writing this right now). I have no idea if the market will keep going up, or if next year will be another 2008. There’s simply no way for anyone to know. The financial media is all too happy to give you their take on what is to come, but they aren’t any more prescient than anyone else. They’ll likely be right about half of the time, and wrong about half of the time – just like anyone else. And while an individual prognosticator may string together some lucky calls, it’s still just luck. But for all of the short term noise, disciplined investors tend to do really well over the long term.)

But this doesn’t mean you should be tinkering with your allocation. It also doesn’t mean you should sit around doing nothing. It does mean you need to keep your portfolio tuned to your appropriate risk tolerance. You should do two specific things (no matter what you think the markets will do):

  • Periodically re-evaluate your risk tolerance
  • Rebalance your portfolio to keep your risk levels where you want them

By doing these two things, you’ll make sure you’re prepared for whatever the markets decide to do.

Your Portfolio Shouldn’t Be a Roller Coaster

It sounds trite, but what you put in your portfolio determines the returns you get out. Your asset allocation is your portfolio’s blueprint, and it should be designed to help you reach your retirement income goals.

A big part of this is based on your risk tolerance – a sort of personal speed limit on how much risk you can handle in your portfolio before you start losing sleep. Many people try and stretch to meet their retirement income goals, so their risk tolerance is their limiting factor. When they reach beyond their risk tolerance to get higher returns in the good times, there’s a good chance they won’t stay disciplined in the bad times.

Figuring out your risk tolerance is one of the most important steps in determining your asset allocation. It’s a difficult and ongoing question. People tend to tolerate less risk as they get older, so you have to keep testing the water to see how your tolerance has changed.

And to make matters even worse, getting this wrong can sidetrack your retirement. The cost of taking too much risk is pretty obvious – when the markets start dropping you won’t be able to stick it out and you’ll miss the recovery.

The flipside can lead to exactly the same roller coaster. If you are in too conservative of a portfolio during the good times, it’s easy to start worrying about the returns you’re giving up. Then you start bumping up the risk in your portfolio so you don’t miss out on the returns everyone else is bragging about.

This would be fine if you did it in a controlled manner and brought yourself up to where you should be – but we all know that’s not what happens. I know how much a serving of ice cream is, but somehow the pint of Ben & Jerry’s ends up disappearing. It’s the same thing when you start adding on risk to “catch up.” You’ll probably end up taking on too much – and then the downturn hits, and you end up panicking and selling.

In other words, you end up buying high and selling low – the exact opposite of what you want to do when you invest. You want to find the portfolio that will help you stay the course – your goldilocks portfolio.

Figuring Out Your Risk Tolerance is Hard

So risk tolerance is important. That’s true, but how do we take that information and turn it into an asset allocation you can use? As humans, we are wildly overconfident about how much risk we can handle, but we also need to beware of recency bias, which means the things that have happened most recently have an outsized impact on our decision-making process. It can be hard to see beyond your current situation, and that’s why recency bias is so dangerous.

It’s impossible to determine your asset allocation without some degree of recency bias. You are going to be influenced by market movements. If you set up your asset allocation in late 2009 – right after the global financial crisis – and haven’t touched it since, I can tell you two things about your portfolio with some degree of confidence:

  1. The risk tolerance you decided on was probably pretty low
  2. It’s probably time to revisit your allocation

The vast (vast) majority of people who set their risk tolerance in late 2009 were probably more conservative than their “true” risk tolerance, simply because 2008 was not a fun year to be in the markets. On the other hand, those people who were able to weather the storm may have decided that since they were able to stay disciplined, they might be able to take on some more risk. There’s really no right answer here.

If you set your asset allocation in the run-up to the global financial crisis, say during 2006, then you very likely thought your risk tolerance was higher than it truly was. The markets were booming in the early 2000s. As a result of our collective recency bias, 2008 was even less fun than it needed to be.

There’s no way to avoid recency bias. It’s just how we are wired. The stuff that’s happened most recently is the freshest in our mind, and drives our emotions. So why should we continually invite these errors?

We need to recalibrate our risk tolerance estimates because we are always learning and changing. After the global financial crisis, you saw how you actually reacted to a big drop in the market. You now know what you did when the market just kept falling – and how this squared with what you thought you would do.

Things are also changing in your life. Has your job situation changed since you last looked at your risk tolerance? How about the rest of your life?

For instance, my wife and I are moving my father-in-law from Shanghai, China to Portland, Maine right now (I’m actually sitting in what will be his new apartment waiting for his mattress to be delivered). That’s a pretty material change that has had an impact on our risk tolerance and what we need from our portfolio.

It’s impossible to eliminate our biases, but we can try and minimize their effects. Simply by recognizing that you are probably being unduly influenced by what’s been happening, you are in a better position to take a step back and look at things (a little bit more) rationally.

You Still Need to Keep Your Portfolio in Line

Let’s say you’ve figured out your risk tolerance and asset allocation. You’ve built a portfolio that fits your goals and needs. Now you need to maintain that portfolio. The markets bounce around – that’s just what they do – and they’ll bounce your portfolio around as well. No matter how brilliant and beautiful your asset allocation is, it doesn’t mean anything unless you can keep your portfolio dialed in.

Now, it’s pretty much impossible for your portfolio to be exactly on target at all times. But you need to be reasonably close.

For instance, let’s say you should have a portfolio that is 60 percent stocks. If that portfolio drifts up to 62 percent stocks, it doesn’t much matter. The markets are noisy enough that a two percent difference isn’t going to be noticeable. But if your portfolio starts drifting up to 66 or 67 percent stocks, then you have an issue. Your portfolio is starting to look significantly different than your asset allocation. You’re taking more risk than you decided was appropriate.

To correct this, you need to rebalance your portfolio. You need to sell the stuff that is overweighted (generally the stuff that has gone up), and buy the stuff that is underweighted (generally the stuff that has gone down). While it feels strange to a lot of people to sell your winners and buy your losers, the goal is to keep your total portfolio in line – and this is the way to do it.

Rebalancing is the boring, unglamorous – and crucial – grunt work of maintaining a portfolio. And it often doesn’t get done. We’ve had an incredibly long bull market recently, and I’d be willing to bet that the average investor is way off from their asset allocation (we’ll leave aside the question of whether the average investor has an asset allocation to rebalance back to).

So let’s see what letting your portfolio run without rebalancing would actually mean.

Let’s say you start off with a portfolio that is 60 percent stocks and 40 percent bonds.(1) Just how big of a deal is it to hold off on rebalancing? Let’s run an experiment and see how much your stock allocation could drift.

What we want to know is how far off from this target weight a portfolio would get over different rebalancing periods. We’ll use a few different rebalancing lengths, and use rolling periods to get a sense of what the drift looks like on average.

Average Stock Weight Maximum Stock Weight Minimum Stock Weight
3 Months 60% 65% 51%
1 Year 61% 68% 45%
3 Years 62% 73% 40%
5 Years 64% 78% 46%
10 Years 66% 80% 38%

Rolling monthly start dates from 1/76 – 8/17. Weights represent the equity allocation immediately prior to rebalance. Past performance is no guarantee of future performance. Indices are not available for direct investment.

As you might imagine, the longer you go between rebalances, the bigger the dispersion you’ll see with your portfolio. While the maximum and minimum stock allocation is interesting and can give us some sense of the bounds we’re working with, we want to focus on the average stock weight.

This is the expected weight of stocks within our portfolio at the end of a rebalance period. And while the numbers (other than the ten years) don’t look too far off from our target allocation, remember that these are actually distributions of results. They go all the way up to the maximum stock allocation, and all the way down to the minimum allocation.

So let’s look at how often the allocation drifts further than we are comfortable with – say five percentage points either way.

Stock Allocation
More than 65%
Stock Allocation
Less than 55%
Stock Allocation
Outside of Range
3 Months 0% 2% 2%
1 Year 7% 10% 17%
3 Years 35% 13% 48%
5 Years 46% 18% 64%
10 Years 74% 11% 85%

Rolling monthly start dates from 1/76 – 8/17. Weights represent the equity allocation immediately prior to rebalance. Past performance is no guarantee of future performance. Indices are not available for direct investment.

This is where the results start getting interesting. Looking at the raw numbers was a start, but this allows us to understand just how important frequent rebalancing actually is. If you let your portfolio drift for three years (which is pretty easy to do if you’re not thinking about it), your portfolio will be out of balance almost half of the time when you go to rebalance (even after only two years, you’re looking at more than one-third of the time.) To put it mildly, this is bad. When you let your portfolio drift like this, you are just making it more difficult for you to stay disciplined.

On the other hand, if you take a more proactive approach to rebalancing, like McLean does, your portfolio sticks very close to your target – helping you stay disciplined no matter what the markets decide to throw your way.(2)

Despite the importance of rebalancing, most people just don’t do it. A study by Wells Fargo and Gallup found that more than half of investors don’t rebalance at least once a year. And even more than that, apparently about one-third of respondents said they would rather be stuck in traffic for an hour than rebalance their portfolio. (We’ll leave aside the fact that rebalancing shouldn’t take anywhere near an hour…)

But there’s always a reason to avoid rebalancing. No matter what is happening, you can always find some reasonable sounding explanation for not rebalancing:

  • When the market is going down – “Stocks are too risky right now.”
  • When the market is going up – “I don’t want to miss out.”
  • When the market is flat – “…” (most people just forget about it when the market is flat)

But even beyond the market conditions, some people try and avoid rebalancing because they are worried about the tax consequences. No one likes to pay taxes, but they are the cost of keeping your portfolio in line (though you may have some opportunities to manage your taxes through tax loss harvesting, asset location, or even being strategic about which accounts you take withdrawals from when you are in retirement).

While there are specific situations where keeping your portfolio out of balance for tax reasons makes sense (if you’re 103 and waiting for the cost basis step up when you pass, or in the process of making a charitable donation of your appreciated securities), you shouldn’t let the tax tail wag the dog.

Markets Can Move Fast

Presumably, you created your asset allocation for a reason. It’s the right level of risk for you. The further you let your portfolio drift from your asset allocation, the more exposed you are to differences from your desired risk levels. And this can make a real difference even over the course of a single day.

To see this in action, let’s look at the daily returns of two portfolios:

  1. 60 percent in the Vanguard 500 Index Fund (which tracks the S&P 500 Index), and 40 percent in the Vanguard Total Market Bond Fund,
  2. 70/30 portfolio using the same two funds.

What sort of difference do we see in their daily returns?

Well, on an average day, there’s really not that big of a difference. The average difference from 12/12/86 – 9/26/17 between the two portfolios is about 0.08 percent per day (this is still a decent amount of money though – with a $1 million portfolio, this is still a difference of about $800 per day).(3) This makes sense as we are moving the stock allocation 10 percent between the portfolios, and over the same period the Vanguard 500 Index fund had an average daily movement of 0.74 percent.

But while that difference adds up over time, what we’re really curious about are the big movements where you can get hurt by letting your portfolio drift.

First off, the biggest difference between the two portfolios was on October 19, 1987 – Black Monday. The difference between the two portfolios was over 2 percent that day. Using that same $1 million portfolio, if you had let your allocation drift from 60/40 to 70/30, you would have lost more than an additional $20,000 in that single day.

Even if we look at (much) less extreme differences, the effects are pretty stark:

  • 1 out of every 33 days the difference was more the 0.3 percent ($3,000 on a $1 million portfolio)
  • 1 out of every 100 days, the difference was more than 0.45 percent ($4,500 on a $1 million portfolio)
  • 1 out of every 200 days, the difference was more than 0.65 percent ($6,500 on a $1 million portfolio)

These may not seem like all that big of differences, but these are reasonably common events. On average, we would expect to see a difference of more than 0.7 percent every year.

But the real impact is on your investment discipline. If these accumulated differences make you (depending on what the market is doing) panic or sell out right after the markets drop, or start buying more stock so you stop missing out, you’ve put yourself right on the fear and greed roller coaster.

The fear and greed roller coaster is not a fun ride. You’re just setting yourself up to buy high and sell low. If you can stay disciplined, you can avoid this cycle and focus on harvesting the long-term gains you want.

Being Disciplined Doesn’t Mean Doing Nothing

Just because we can’t predict the future doesn’t mean we should sit on our hands. You’re not Ron Popeil, and you can’t set it and forget it. Every portfolio needs to be managed and manicured to make sure you are getting the level of risk that’s appropriate for you.

This starts with making sure that you have the right level of risk in your asset allocation, and then making sure that your portfolio reflects your asset allocation. There’s no point in spending the time to get your asset allocation right if you let your portfolio drift all over the place.

Managing your portfolio is never over. And it’s also never going to be perfect. This is always going to be a process of successive approximation. It’s like driving a car – you need to make constant adjustments to stay on the road. You can never really let go of the wheel – at least for very long. Your portfolio works the same way. If you stop paying attention, your portfolio is liable to go off the road.

To find out how McLean manages our clients’ portfolios (or understand what you should be doing for your own portfolio), take a look at our “Day in the Life of a Portfolio” ebook.

(1) Represented by the S&P 500 Index and the Bloomberg Barclays US Aggregate Bond Index, respectively.

(2) We automatically check the allocation of all client accounts on a weekly basis, and manually review them every quarter to make sure all clients are invested appropriately. For more information, see “A Day in the Life of A Portfolio.”

(3) Since I want the difference between the two returns, I am subtracting the return of the 70/30 portfolio from the return of the 60/40 portfolio and taking the absolute value.

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