Aurum Wealth Management Blog

The Psychology of Rebalance

The father of Modern Portfolio Theory in 1951 did not actually stick to his breakthrough theory with his own money, which is kind of odd considering all of his accolades.  Instead, Harry Markowitz preferred to minimize his future regret bias and split his personal portfolio 50% stocks and 50% bonds.

According to Jason Zweig (of the Wall Street Journal), Markowitz said, "I visualized my grief if the stock market went way up and I wasn't in it – or it went way down and I was completely in it.  So I split my contributions 50/50 between stocks and bonds."  Zweig goes on, "Economists in his day believed powerfully in the concept of 'economic man' – the theory that people always acted in their own best self-interest.  Yet Mr. Markowitz, famous economist though he was, clearly was not an example of economic man."  In doing so, he also proved a theory that would come along decades later, that psychology affects behavior in finance and with portfolios.

Let's take a naïve 50% stock /50% bond portfolio and rebalance it once a year, to see how it performed over the last 20 years.


The returns of the 50/50 portfolio capture 95% of the upside of the S&P 500 with only about half of the volatility or risk over this period.  In addition, the biggest drawdowns only capture 39% and 28% of the downside, and limit the pain when the stock market was cut in half in 2001-2002 and 2008-2009.  (The example does not include the friction costs of taxes or trading fees for simplicity.)

A reason for the strong risk-adjusted performance is the negative correlation between bonds and stocks over the last 15 years.  That is, when stocks go down, bonds have gone up.  This relationship does not always hold, as the chart below shows, in the 1970s bond and stocks had a positive correlation, negating some of the diversification benefits.



"It is quite counter-intuitive to decrease that part of one's activity that has recently worked best.  But this is a good idea… instead of increasing the risks in an attempt to satisfy perceived needs."  – Charlie Munger, Poor Charlie's Almanac

The portfolio gets quite lopsided and one must sell the outperforming security (stocks) and buy the underperformer (bonds).

Where does the psychology come in?  According to a 2013 paper by Thomas Howard (professor at the University of Denver) on behavioral portfolio management, the first principle is that security prices are predominately set by emotional crowds of investors.  Emotional crowds are propelled by two forces: a deep-seated aversion to short-term losses and a compulsive need for social validation.

If the 50/50 portfolio mix was the strategic allocation chosen, the investor must fight the consensus of the crowd today that are saying all bond yields will rise rapidly and, instead, actually buy bonds.  At the same time, one must sell stocks that went up dramatically last year perhaps selling stocks one likes for the long-term to rebalance back to the base weight.  Clearly doing both of these bring up fears of further short-term losses of buying bonds today if they continue to fall in price (the Long Treasury Bond index fell 13% in 2013) in addition feeling left out of the crowd that are excited about stocks (with sentiment surveys at the most bullish levels in years).

Monitoring position weights, asset class expectations, and correlations is part of our portfolio management process on a daily basis. This simple example using two assets shows the benefits of rebalancing, whereas our portfolios include multiple asset classes with sub-asset classes, sectors, and styles within these to further diversify risk and increase the opportunity set.   The example shows the theory works, but in practice behavioral biases matter.   As Harry Markowitz's action showed us, it is not easy even for an academic portfolio maven.   Yogi Berra was on to something when he said, "In theory there is no difference between theory and practice.  In practice there is."

If you have any questions on rebalancing your portfolio, please contact Aurum Wealth Management Group at 440-605-1900 or visit our website at Stay up to date – follow us on Twitter @aurumwealth and to receive weekly investment-related updates, sign up for our free newsletter.
This material is based on public information as of the specified date, and may be stale thereafter. We make no representation or warranty with respect to the accuracy or completeness of this material. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates. Other events not taken into account may occur and may significantly affect the projections or estimates. Certain assumptions may have been made for modeling purposes only to simplify the presentation and/or calculation of any projections or estimates, and Aurum Wealth Management Group and/or Aurum Advisory Services does not represent that any such assumptions will reflect actual future events. Accordingly, there can be no assurance that estimated returns or projections will be realized or that actual returns or performance results will not materially differ from those estimated herein. This material should not be viewed as advice or recommendations with respect to asset allocation, any particular investment, or any tax advice.

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