Are financial advisers really right about the benefits of rebalancing and diversification?
Posted by John Reed on
Financial “experts” recommend periodic rebalancing. Mostly they speak of the percentage of bonds versus stocks.
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I can help you with that. The percentage of bonds should be zero because they are disasters in inflation.
.
Lately, the financial “experts” say the bonds you own must be TIPS and/or ibonds inside a tax-deferred pension account like an IRA.
.
I wrote a fairly thorough article about TIPS at https://johntreed.com/blogs/john-t-reed-s-news-blog/why-treasury-inflation-protected-securities-do-not-adequately-protect-you-from-inflation?_pos=8&_sid=e4dcfe9cf&_ss=r
.
I also wrote about limitations of tax-deferred pension accounts at https://johntreed.com/blogs/john-t-reed-s-news-blog/problems-with-iras-and-401ks-you-probably-never-heard-about
.
Rebalancing can also refer to restoring an initial mix of other assets.
.
The basic idea of rebalancing is that there is an ideal mix of different assets that you can discern. Therefore as the values change—if your balance formula is based on market values—you need to periodically restore that ideal balance. If you had, for example, one share of each stock, no rebalancing, except that existing corporations cease to exist and other new ones come into existence. In, say, an S&P 500 fund, you have to do a few transactions to keep the number of stocks at 500. But if the mix was based on current values of each stock and bond, far more transactions would be needed.
.
First, the main inarguable point about index funds is that they minimize management fees, gains taxes, and transaction fees by avoiding buying or selling. Rebalancing means buying and selling and whatever fees or taxes that charges. So the alleged benefit of rebalancing must exceed the cost of rebalancing. For it to make sense.
.
But as I find myself saying so often when I talk about the financial “expert,” choosing the “correct” balance between stocks and bonds between stocks, or foreign currencies and so on is actually predicting the future and that is impossible.
.
I do have a general rebalancing thought about my seven foreign currencies. My CHF and DKK have been nicely stable. CHF are also far more liquid. So I tend to give them a higher share. But the fact that DHF and DKK WERE stable in the past does not predict future behavior. The main thing is the total amount I have in foreign currencies and that it is spread over seven currencies is probably enough diversification.
.
Before you get too excited about annual rebalancing, be able to explain FOR SURE why the original mix of assets is absolutely better than the current mix after some of the assets changed market value. Maybe the de facto new mix percentages caused by some assets appreciating and others falling in value have resulting in a BETTER mix. More money in the assets that did well recently.
.
Diversification—not putting all your eggs in one basket—only protects against risks that do not affect the whole basket. Each stock is a basket, but so is the entire stock market, which simultaneously fell in 1929, 1937, 1962, 1987, 1989, 2000, 2008, 2020. These generally had different causes, but there is no denying that some events affect the entire stock market all at once. In these instances, one of the gods of modern financial advice, diversification among lots of different stocks, don’t mean nothing.
.
Also, it calls to mind my great critique of diversification. Diversification is not 500 stocks or 5,000 stocks. Diversification that protects against everything involves investing in EVERYTHING, not just the freaking New York Stock Exchange. Wall Street thinks it’s the center of the universe. But even a total index fund owning every stock in America would not have protected you from the above crashes.
.
But my Dad’s family was diversified in a way that protected them from the Great Depression. They owned a 500-acre subsistence farm in WV. I visited it a number of times. Mostly mountains and trees—paid to one of my ancestors for his service as a lieutenant in the Revolutionary War. It had game including deer and herds of elk. I saw them. It had a stream big enough to almost be called a river. It had fish. I caught and ate some. They built a house from lumber from the property’s trees. They had water from a spring. And mainly, they grew crops, all the various fruits, grains, and vegetables, and a large field of grain to sell for cash, and raised livestock. Generally, they ate the food that they raised. No finance was involved. My dad said his family did not know that the Depression happened until they heard about it in town.
.
Diversification that causes you to be unaware of the Great Depression? THAT’s diversification!
.
I am not advocating that you buy a subsistence farm. Those are really quite inefficient because they are devoid of division of labor. But they make my point that the notion that diversification is something that happens with the stock or bond market is ridiculous.
.
One thing you CAN do that accomplishes much the same is stockpiling regular and long shelf-life food—dry pack (Mormon) and freeze dried (Mountain House).
.
Are commodities diversification? Absolutely. What are they? Oil. Gold. Nickel. Aluminum. Lithium Carbonate. Corn. Rice. Wool. Butter. Lard. Eggs.
.
For the tight-assed Wall Street people, they would not phyically touch any of these. Rather, they charge you to take long or short positions in these commodities by way of call and put options that expire in one to three months. These are very risky, have transaction costs, and are complicated.
.
The people buying and selling commodities in the futures markets never lay eyes on the butter or oil or whatever. At West Point when I was a cadet, they told of an apocryphal officer who made investments in commodities while he was an officer teaching at West Point. One day, so the story goes, he made a mistake and had to TAKE DELIVERY of a train car load of wheat at the West Point rain station.
.
Rebalancing and diversification solely with registered securities, are like religious commandments among those who purport to be financial experts. Do not accept them as such. Think about whether they violate the principle that the future is impossible to predict.
.
I do not believe that ever happened. The mercantile exchanges have procedures for liquidating contracts on paper and with money changing hands. The transactions are financially connected to the commodities, but securities speculators do not take delivery, including by accident, of train cars full of grain, etc.
.
I believe simple is better than complex. In commodities, simple means take delivery. I have taken delivery of pennies (zinc and copper), nickels (nickel and copper), junk silver (pre-1965 dimes, quarters, and half dollars) and gold coins minted by the US government. I did not go to a licensed securities deal or mercantile exchange. I bought them at a bank or coin store. There were no futures options. Just coins that I paid for in cash.
.
During hyperinflation, you should be able to go to a coin dealer with such coins and trade them for a lot of hyperinflated currency with which to buy groceries in the US. They are assets that constitute diversification and hedges against inflation risk. Could licensed securities dealers sell you gold coins? Yes. Do they? No, such a transaction would be beneath them, not befitting their bespoke suits. Not complicated enough.
.
I do not know if the financial salesmen will sell you foreign exchange, which would be a fabulous liquid hedge against USD hyperinflation. You do not need them. Keep it simple. Just open accounts in Canada, Australia, and New Zealand which is almost identical to opening one in the US. Or buy paper foreign currency from a bank or local currency dealer.
.
I can help you with that. The percentage of bonds should be zero because they are disasters in inflation.
.
Lately, the financial “experts” say the bonds you own must be TIPS and/or ibonds inside a tax-deferred pension account like an IRA.
.
I wrote a fairly thorough article about TIPS at https://johntreed.com/blogs/john-t-reed-s-news-blog/why-treasury-inflation-protected-securities-do-not-adequately-protect-you-from-inflation?_pos=8&_sid=e4dcfe9cf&_ss=r
.
I also wrote about limitations of tax-deferred pension accounts at https://johntreed.com/blogs/john-t-reed-s-news-blog/problems-with-iras-and-401ks-you-probably-never-heard-about
.
Rebalancing can also refer to restoring an initial mix of other assets.
.
The basic idea of rebalancing is that there is an ideal mix of different assets that you can discern. Therefore as the values change—if your balance formula is based on market values—you need to periodically restore that ideal balance. If you had, for example, one share of each stock, no rebalancing, except that existing corporations cease to exist and other new ones come into existence. In, say, an S&P 500 fund, you have to do a few transactions to keep the number of stocks at 500. But if the mix was based on current values of each stock and bond, far more transactions would be needed.
.
First, the main inarguable point about index funds is that they minimize management fees, gains taxes, and transaction fees by avoiding buying or selling. Rebalancing means buying and selling and whatever fees or taxes that charges. So the alleged benefit of rebalancing must exceed the cost of rebalancing. For it to make sense.
.
But as I find myself saying so often when I talk about the financial “expert,” choosing the “correct” balance between stocks and bonds between stocks, or foreign currencies and so on is actually predicting the future and that is impossible.
.
I do have a general rebalancing thought about my seven foreign currencies. My CHF and DKK have been nicely stable. CHF are also far more liquid. So I tend to give them a higher share. But the fact that DHF and DKK WERE stable in the past does not predict future behavior. The main thing is the total amount I have in foreign currencies and that it is spread over seven currencies is probably enough diversification.
.
Before you get too excited about annual rebalancing, be able to explain FOR SURE why the original mix of assets is absolutely better than the current mix after some of the assets changed market value. Maybe the de facto new mix percentages caused by some assets appreciating and others falling in value have resulting in a BETTER mix. More money in the assets that did well recently.
.
Diversification—not putting all your eggs in one basket—only protects against risks that do not affect the whole basket. Each stock is a basket, but so is the entire stock market, which simultaneously fell in 1929, 1937, 1962, 1987, 1989, 2000, 2008, 2020. These generally had different causes, but there is no denying that some events affect the entire stock market all at once. In these instances, one of the gods of modern financial advice, diversification among lots of different stocks, don’t mean nothing.
.
Also, it calls to mind my great critique of diversification. Diversification is not 500 stocks or 5,000 stocks. Diversification that protects against everything involves investing in EVERYTHING, not just the freaking New York Stock Exchange. Wall Street thinks it’s the center of the universe. But even a total index fund owning every stock in America would not have protected you from the above crashes.
.
But my Dad’s family was diversified in a way that protected them from the Great Depression. They owned a 500-acre subsistence farm in WV. I visited it a number of times. Mostly mountains and trees—paid to one of my ancestors for his service as a lieutenant in the Revolutionary War. It had game including deer and herds of elk. I saw them. It had a stream big enough to almost be called a river. It had fish. I caught and ate some. They built a house from lumber from the property’s trees. They had water from a spring. And mainly, they grew crops, all the various fruits, grains, and vegetables, and a large field of grain to sell for cash, and raised livestock. Generally, they ate the food that they raised. No finance was involved. My dad said his family did not know that the Depression happened until they heard about it in town.
.
Diversification that causes you to be unaware of the Great Depression? THAT’s diversification!
.
I am not advocating that you buy a subsistence farm. Those are really quite inefficient because they are devoid of division of labor. But they make my point that the notion that diversification is something that happens with the stock or bond market is ridiculous.
.
One thing you CAN do that accomplishes much the same is stockpiling regular and long shelf-life food—dry pack (Mormon) and freeze dried (Mountain House).
.
Are commodities diversification? Absolutely. What are they? Oil. Gold. Nickel. Aluminum. Lithium Carbonate. Corn. Rice. Wool. Butter. Lard. Eggs.
.
For the tight-assed Wall Street people, they would not phyically touch any of these. Rather, they charge you to take long or short positions in these commodities by way of call and put options that expire in one to three months. These are very risky, have transaction costs, and are complicated.
.
The people buying and selling commodities in the futures markets never lay eyes on the butter or oil or whatever. At West Point when I was a cadet, they told of an apocryphal officer who made investments in commodities while he was an officer teaching at West Point. One day, so the story goes, he made a mistake and had to TAKE DELIVERY of a train car load of wheat at the West Point rain station.
.
Rebalancing and diversification solely with registered securities, are like religious commandments among those who purport to be financial experts. Do not accept them as such. Think about whether they violate the principle that the future is impossible to predict.
.
I do not believe that ever happened. The mercantile exchanges have procedures for liquidating contracts on paper and with money changing hands. The transactions are financially connected to the commodities, but securities speculators do not take delivery, including by accident, of train cars full of grain, etc.
.
I believe simple is better than complex. In commodities, simple means take delivery. I have taken delivery of pennies (zinc and copper), nickels (nickel and copper), junk silver (pre-1965 dimes, quarters, and half dollars) and gold coins minted by the US government. I did not go to a licensed securities deal or mercantile exchange. I bought them at a bank or coin store. There were no futures options. Just coins that I paid for in cash.
.
During hyperinflation, you should be able to go to a coin dealer with such coins and trade them for a lot of hyperinflated currency with which to buy groceries in the US. They are assets that constitute diversification and hedges against inflation risk. Could licensed securities dealers sell you gold coins? Yes. Do they? No, such a transaction would be beneath them, not befitting their bespoke suits. Not complicated enough.
.
I do not know if the financial salesmen will sell you foreign exchange, which would be a fabulous liquid hedge against USD hyperinflation. You do not need them. Keep it simple. Just open accounts in Canada, Australia, and New Zealand which is almost identical to opening one in the US. Or buy paper foreign currency from a bank or local currency dealer.
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