# Does Portfolio Rebalancing Work?



## Panaman (12 April 2014)

Running my own SMSF and always on the lookout for different ideas to help maximise returns and read an article on re balancing, that is every 3 months or whatever time frame you choose you re balance your portfolio, so say you want 50% shares, 40% bonds and 10% property at the end of each quarter you have had a good run in shares and your now 60% shares, 35% bonds, 5% property, you sell 10% of your shares and buy 5% each in bonds and property to get your allocation back to its desired risk level.

In many ways it seems to me this forces you to sell high and buy low, does anyone run there super/investments in this way and how often would a rebalance take place, also what are the pros and cons and most importantly does it work?


----------



## DeepState (12 April 2014)

It works. It works across and within asset classes. It works because you are 'harvesting' the volatility of markets.  Prices zig and zag.  If you do not rebalance, you have zero probability of participating in a situation where sequential moves are in opposing directions.  Rebalancing allows you to capture it.  The more volatile the assets are and the less correlated, the bigger your rebalancing profits are going to be.  And these can be very meaningful.  Further, it's not as if you need to be an investment genius to do it.  The key question is whether transaction costs exceed the rebalancing profit expectation. 

Instead of going through the maths for that, which gets into thermonuclear equations, just rebalance each six months or year and that'll do you.

Congratulations, you've probably added 0.5% or more to your returns each year. Compound that up for 20 to 30 years and you've just found a way to materially add to your expected wealth.

Disclaimer: This is not advice.  It is...entertainment.  Do your own work.  I do not know your circumstances.


----------



## Julia (12 April 2014)

Panaman, the option I've used for many years is to simply let my profits run and cut losers short quickly.
If that means an 'unbalanced' p/f I'm quite OK with that.   Have never seen the point in diversification for the sake of it.

Also be willing to switch asset classes when appropriate.  You have a SMSF which gives you the complete freedom to do this.  If property, e.g., is outperforming shares at a given time, then you could consider switching.   With the all the chaos and uncertainty when the GFC occurred, there were some excellent cash options available.  

Do what works for you.  Don't be unnecessarily confused by admonitions that there is only one correct way.
Good luck.


----------



## McLovin (12 April 2014)

Julia said:


> Have never seen the point in diversification for the sake of it.




Me neither. And I think unless you're running a $20b pension fund, academic discussions about rebalancing to generate alpha are just that. One thing the private investor has to their advantage is size. There's plenty of low hanging fruit (whether you approach the market technically or fundamentally) so that, IMO, is where the private investor should devote their energy.


----------



## DeepState (12 April 2014)

McLovin said:


> I think unless you're running a $20b pension fund, academic discussions about rebalancing to generate alpha are just that. One thing the private investor has to their advantage is size. There's plenty of low hanging fruit (whether you approach the market technically or fundamentally) so that, IMO, is where the private investor should devote their energy.




Rebalancing the asset allocation of your portfolio is easily achieved at retail size as well as insto.  Admittedly, managing stock portfolios is more challenging for small sized portfolios.  It depends on your motivation and your edge.  Net results for retail, despite implementation advantages you mention, are uniformly woeful all over the place.  Here is a method which basically works.  There's no trick or magic to it.  It's unexciting.  But, it provides an edge that totally overwhelms the average outcome given time.  As usual, 80-90% will think themselves above the odds and...let's say...add volatility and liquidity to the market for others to collect. Fantastic.

Presumably, the initiator of this thread has a long term neutral view of what their asset allocation should be.  They clearly are aware that drift in the actual allocations will result in portfolio risk which is inconsistent with their aims.  In the absence of some insight....is rebalancing so stupid or worthless?  As for being academic, I guess a couple of $100bn run this way explicitly and growing like a weed might give you reason to consider the possibility that it has escaped from the labs, actually seen sunlight and probably even had a date! You can even buy ETFs and unit trusts making them directly accessible to those with less than $20bn.

Overall, it's just an idea.  One of many in this ocean to choose from.  But it works. There is no other free lunch available in investments other than diversification if you intend to stay out of prison. Why not take 5 minutes to eat it. You could do a lot worse, and most will despite what they think up front.  Many will think the size of the advantage is small and think they can do much better.  Take a class photo....and let's see where they are in the 10 year reunion.  You know already know what the outcomes are going to be in aggregate, you just don't know who will fill which slot on either side of the line...and everyone thought they'd be on the right side of it at the outset.

Can you be bothered implementing it?  Is it worth your time?  Perhaps that's what you mean.  I think it's worth it for asset allocation.  That's easy. Perhaps the original question should be phrased 'given the profits available from rebalancing your asset allocation, and the ease with which it is achieved, why wouldn't you rebalance ?'.  You can achieve it in 5 mins. A couple of phone calls or click-through futures trades. Leaving plenty of time for other investment activity. If your profit per minute could be sustained at this level, your wealth would exceed $20bn before too long.  Would you regard that as a poor allocation of time? Surely not.

Cheers.

Disclaimer: This is not advice. I do not know your circumstances. Please do your own work. I am not endorsing any ETF or unit trust.


----------



## Smurf1976 (12 April 2014)

Julia said:


> Panaman, the option I've used for many years is to simply let my profits run and cut losers short quickly.
> If that means an 'unbalanced' p/f I'm quite OK with that.   Have never seen the point in diversification for the sake of it.




Pretty much the same here, although I'm a bit more patient with the losers if the business remains sound and it's just a case or me buying in too early. I guess that depends on how you define a "loser".



> Also be willing to switch asset classes when appropriate.  You have a SMSF which gives you the complete freedom to do this.  If property, e.g., is outperforming shares at a given time, then you could consider switching.   With the all the chaos and uncertainty when the GFC occurred, there were some excellent cash options available.




I think one big mistake that many make is to assume that average conditions always apply. Eg stocks outperform cash over the long term, therefore they assume they need to be in stocks right now even though the market's heading down and banks are paying 10% interest (hypothetical example).


----------



## McLovin (13 April 2014)

DeepState said:


> Rebalancing the asset allocation of your portfolio is easily achieved at retail size as well as insto.




Actually, I meant unless you're an insto, who by virtue of size has a much harder time trying to beat the market, there are much easier ways to juice much more than 0.2% (Is that pre or post tax?).


----------



## DeepState (13 April 2014)

McLovin said:


> Actually, I meant unless you're an insto, who by virtue of size has a much harder time trying to beat the market, there are much easier ways to juice much more than 0.2% (Is that pre or post tax?).




Hi McLovin

Nicely worded.  That 0.2% is pre tax [you were referring to the four bank example from SMURF1976 in a different thread? In rebal to SAA correlations are lower and the gain is higher depending on what you are rebalancing]. In an SMSF, you keep a lot of it.  If you have easier ways to juice the market, you should do it.  But it would need to be something out of this world not to spend 5 mins rebalancing each 6 months to achieve that outcome in equivalent time.  Then, after you've deployed 5 minutes, juice away.

Insto also works at lots of things to juice their portfolios and has tricks up sleeves to manage t-cost that I'm not sure you fully appreciate.  The median insto manager in Australian equities large cap beats the index by about 1-2%.  The retail investor, with virtually no market impact (but higher bro) gets about -2%.  Perhaps your extrapolations on insto performance and retail need to consider more factors than t-cost. Yet insto does this because it is simple and it works.  Not from desperation.  Insto knows not to leave money on the table.  They do it for AUM well below $1bn too.

But, hey, maybe it's "whatever".  To me, the power of compound interest is serious stuff and a little here and a little there over time makes a very big difference. Most people don't appreciate it, preferring bright lights and the promise of big returns. It's a cognitive bias that you can check for by sticking someone's head into an fMRI machine and seeing which parts of their brain light up when giving them the choice of a boring 0.5% per annum and some hot idea. Naturally, it costs them money.  In the field of behavioural finance, it is known as the Lottery Effect. 

Rebal is just one piece of building and maintaining portfolios.  It comes with low governance requirement and execution load. It's not as if I or insto ignores the opportunity to juice it up beyond that. And some of that is truly staggering stuff - juicing entire dumpsters at a time.  With only 10 minutes a year on rebalancing....there are 365days-10mins available to hunt elsewhere each year.   

If it's not for you...no worries.  Just an idea.


----------



## skc (14 April 2014)

Here's a 20-year return matrix.

Do some analysis and see if rebalance gives you an edge.

http://www.bullionvault.com/US_Annual_asset_performance_comparison_1973-2013.pdf


----------



## luutzu (21 April 2014)

Panaman said:


> Running my own SMSF and always on the lookout for different ideas to help maximise returns and read an article on re balancing, that is every 3 months or whatever time frame you choose you re balance your portfolio, so say you want 50% shares, 40% bonds and 10% property at the end of each quarter you have had a good run in shares and your now 60% shares, 35% bonds, 5% property, you sell 10% of your shares and buy 5% each in bonds and property to get your allocation back to its desired risk level.
> 
> In many ways it seems to me this forces you to sell high and buy low, does anyone run there super/investments in this way and how often would a rebalance take place, also what are the pros and cons and most importantly does it work?






Careful you don't "cut the flowers and watering the weed" - Peter Lynch.

i personally don't diversify for the sake of diversification. I put all mine in stocks and diversify within that... it sounds risky but it'd be riskier doing things i don't know.

Also, given the current low interest rate, why would you want to lend money through buying bonds? Or the high property market, why you would go out and buy property now? 

Through stocks, you can diversify into these other assets... e.g. buy a property developer like Australand or stockland


----------



## ROE (21 April 2014)

Do what works for you.. Forget all these academics and theory
Most don't work in real world for retail investor.

Retail investors has plenty of advantages that only experience
tell you.... It doesn't covered in theory or academic paper.


----------



## DeepState (21 April 2014)

ROE said:


> Do what works for you.. Forget all these academics and theory
> Most don't work in real world for retail investor.
> 
> Retail investors has plenty of advantages that only experience
> tell you.... It doesn't covered in theory or academic paper.




Agreed...do what works for you.

Disagree...the rest.

We are all self taught.  How each of us learns is unique, but it seems rather limiting to dismiss a body of massive effort on the grounds that most don't work.  Strangely, most investment strategies attempted don't work either.  Should we advocate dismissing all of that too on the grounds that most of them don't work in the real world?

As a practitioner who was privileged/suffered intense learning in the cauldron of the real world and really big money we sought out every advantage we could find.  We weren't too proud of where it came from.  I even read a few academic journals and found some to be informative and some to be very useful in developing my world view.  I worked with some ex-academics and  worked with some street animals.  Both were a fruitful source of learning.

Investments is about getting to the truth faster than the next guy.  It doesn't seem advisable to cut off a major source of potential advantage with a hand wave.

Given  the context of this thread and this pushback, let's search for truth.

The question was: Does rebalancing add value?
The answer, in my opinion, is YES.
Should you disagree, please point out where the error is in the equations and logic scattered all over the place.  I will make you famous and rich.

Is this idea academic?  Let's see.
The idea was developed by a guy called ER Fernholz.  An academic?  He developed it whilst working on an FX desk at a major bank.  The firm he went on to found has around $50bn in AUM now.
It was further developed by David Booth.  An academic?  No, not really. He utilized these techniques to build a monster firm, made himself a billionaire and then gave a couple of hundred million to Chicago Business School to thank them for the lessons he learned - from academics - that he used to make him rich.  It was the largest corporate donation in US history.  That's why Chicaco Business School is known as Chicago Booth.
It's now applied to more than $300bn world wide on a pure basis...seemingly thriving in the real world.

RoE, you have indicated that you use a dividend screen as a key part to your analysis.  This was brought to the public by Fisher Black, then an academic, in 1976.  If you read some academic stuff, it might have lessened the cost or duration of your education - unless you pre-dated this.  Fisher Black would probably have won a Nobel but has his life cut short.  He left academia and ended up as an MD at Goldman.  Escaped to the real world.  That said, well done on coming to this conclusion. There is merit.

Apart from the impost of market impact from trading, I would be curious as to what things are available to retail which are somehow not available to insto and how you could be so confident they aren't contained in something that someone in the world has researched and maybe put into writing for the public to examine and develop from?  Making a claim that you are smarter than all of academia is rather a large statement - even if, hypothetically, 95% might be numbskulls. 

Whilst everyone is free to pursue life as they see fit and invest as they see fit (short of joining SAC Capital), it seems rather limiting to exclude swathes of thinking from any source in a competition for truth.

In any case, this rebal stuff was invented and implemented by people outside of the academy.  Do what feels right to you, but make an informed choice.


Disclaimer:  I do not take responsibility for the work of David Both or Fernholz, or necessarily endorse them individually.  This is not advice.  Please do your own work.

_Victorious warriors seek to win first then go to war, whilst defeated warriors seek war first and then seek to win_. - Sun Tzu  

_If I can see further it is by standing on the shoulders of giants_. - Isaac Newton


----------



## luutzu (21 April 2014)

Rebalancing, diversification across asset classes are only useful and profitable if it's done for the right reason. Most often it's just done so it spread the risk of one asset class going down and fund managers not getting any bonuses for the year, or it's advised so your financial planners get a fee and their sponsors get more commissions.

Let say your business is construction and infrastructure engineering, and just so your business is diversified, a hired consultant tells you to get into bio technology or financial management. 

You might be able to do it, but chances are it's riskier than doing what you know, explore opportunities your current operations could build on.

But say you have the knowledge, the money, the opportunities... and having x% already in stocks, you could no longer find any opportunities offering a higher possible return than this bonds offering, or this foreign currency opportunity...and you know, with reasonably good chances, that you'll make higher return in other asset classes, then yea, take it. 

But to simply rebalance and diversify to spread the risk... I think often it's to spread the risk of the advisers and managers getting it wrong than anything beneficial for the client.

You don't see a brain surgeon going to plumbing school in case the surgery business get a bit slow sometime.

---
 Didn't one of the Black Schole guy programmed the systems for Long Term Capital Management, losing billions and almost bring down the world's financial system?


I think that quote from Newton was made to insult this other guy who claimed Newton copied his works, the guy being short, Newton said if i can see further, it's because i stand on the shoulders of giants, not a midget like yourself.   Good quote though.

The other Sun Tzu quote is also good: the ability of an army to move depends on intelligence (inside knowledge). Too bad it's illegal.


----------



## DeepState (22 April 2014)

luutzu said:


> Rebalancing, diversification across asset classes are only useful and profitable if it's done for the right reason. Most often it's just done so it spread the risk of one asset class going down and fund managers not getting any bonuses for the year, or it's advised so your financial planners get a fee and their sponsors get more commissions.
> 
> Let say your business is construction and infrastructure engineering, and just so your business is diversified, a hired consultant tells you to get into bio technology or financial management.
> 
> ...




I really enjoy your writing and ideas.  Please keep going.

I have sympathy for your views on over diversification and agency conflict. They are very reasonable and what you are saying does go on.  In this thread, the question was about rebalancing across existing asset classes.  Panaman is already in the asset classes and talking about relatively small moves.  If Panaman is asking these questions, I imagine that he is somehow capable of making this decision and hence it is relatively free of the agency risks you are referring to.

It was Scholes and Merton who worked in LTCM.  Together with Black, they invented the Black-Scholes-Merton model for options pricing. Black-Scholes invented it first and then Merton found a simpler way to do it.  So now they all share ownership.  It remains in use today as the primary tool for options pricing.

Hahaha on Newton...I did not know that.  That's fantastic.

Yeah, don't do inside info or stock manipulation.  I know people who have gone to jail for it.  Very very naughty. I feel bad for their families.

Take care.


----------



## TPI (24 April 2014)

DeepState said:


> It works. It works across and within asset classes. It works because you are 'harvesting' the volatility of markets.  Prices zig and zag.  If you do not rebalance, you have zero probability of participating in a situation where sequential moves are in opposing directions.  Rebalancing allows you to capture it.  The more volatile the assets are and the less correlated, the bigger your rebalancing profits are going to be.  And these can be very meaningful.  Further, it's not as if you need to be an investment genius to do it.  The key question is whether transaction costs exceed the rebalancing profit expectation.
> 
> Instead of going through the maths for that, which gets into thermonuclear equations, just rebalance each six months or year and that'll do you.
> 
> ...




If I sell shares I bought in July 2013 in Jun 2014, I end up paying almost 50% in CGT on this rebalance... is it still worth it?

If I sell in July 2014 I end up paying almost 25% in CGT on this rebalance... is it still worth it?

Can't see how it is worthwhile unless your are in tax-free pension mode.


----------



## brty (24 April 2014)

TPI,

Rebalancing, from some limited research, within the category of shares, will only work with a group of shares going up in price. 

If the portfolio includes shares that go down in price and stay down (or go bust) then underperformance can be expected. Another weakness with rebalancing is that it cuts the big winners off at the knees. For the longer term portfolio, 1 or 2 shares that are multibaggers are often the basis for a large percentage of the overall gain.

 If you take small gains off these and cut the number of shares in the winners, while adding to losers, the long term result is certain, loss and underperformance. Only if the losers turn around can the system work. The assumption of returning to the mean will work most of the time with fundamentally sound companies, it is the times that it doesn't work that will destroy the portfoilio in the long term.

I still can't find a system that is better than simple buy, add to winners, cull losers quickly. Simple to say, simple to understand, very hard to do for most.


----------



## TPI (25 April 2014)

brty said:


> I still can't find a system that is better than simple buy, add to winners, cull losers quickly. Simple to say, simple to understand, very hard to do for most.




Agree, though I think that this can be done either with a trader's approach or a long-term investing approach, where the long-term investor culls losers not based on short-term changes in share price but on known and fundamental changes to the quality of the underlying business, the sustainability of its earnings and future dividend payments.


----------



## So_Cynical (29 April 2014)

Something occurred to me today...to keep it simple lets look at a 2 stock, 10K portfolio.

With Rebalancing

$5000 of ABC stock and $5000 of XYZ stock, 1 year passes and ABC has gone up 50% ($7500) and XYZ has gone down 50% ($2500) and we rebalance taking $2500 out of ABC and buying $2500 worth of XYZ so we are back to $5000 of each, 1 year passes and both stocks have gone up 50% so *we now have $15000 worth of stock.*



--------------

With NO rebalancing

$5000 of ABC stock and $5000 of XYZ stock, 1 year passes and ABC has gone up 50% ($7500) and XYZ has gone down 50% ($2500) and we do nothing,  1 year passes and both stocks have gone up 50% ~ our ABC stock is now worth $11250 and our XYZ stock is now worth $3750 so *we now have $15000 worth of stock*.

:dunno:

Did i miss something?


----------



## brty (29 April 2014)

So-Cynical,

Yes you did miss something.

The $2500 gain on ABC in the first year is taxable, so at the 30% tax rate thats $750, plus 2 lots of transaction fees extra. Net result, worse off with rebalancing.

See what happens to your 2 stock portfolio if ABC goes up 50%/a for 5 years and XYZ goes down 50%/a for 5 years. That's when you see the risk of rebalancing.


----------



## skc (29 April 2014)

So_Cynical said:


> :dunno:
> 
> Did i miss something?




Rebalancing isn't printing money, it's just an edge. It has a positive expectancy, but it doesn't mean it will work in all combinations of stocks and return profiles... especially with just 2 stocks over two time periods. 

I don't know if this rebalancing bonus is "law of nature" like gravity. However, given that some researcher has done lots of analysis and found that to be the case over their period of observation, then it is likely to be repeatable until there are substantial changes in the behaviour of the stock market and its participants.


----------



## DeepState (29 April 2014)

So_Cynical said:


> Something occurred to me today...to keep it simple lets look at a 2 stock, 10K portfolio.
> 
> With Rebalancing
> 
> ...




Hi So_Cynical.  In terms of the basics of your thought experiment, no you did not miss anything.  The reason why this particular path way did not add value is that both stocks moved upwards in the second period by exactly equal proportions.  When that happens, rebal can't make money - but it doesn't lose you money either.  But, as you know, stocks very rarely move up or down in identical rates of return.  When they differ, particularly if they revert relative to one another from the returns prior to rebalancing, rebalancing makes money.  So, given stocks move around, sometimes in the same direction as prior period to rebal (no money to be made) and sometimes in opposing directions to movement prior to rebal (money gets made), overall there is a positive expectancy [you'd see HR around 0.5 and slug >1].  But, as you know given you apply an average down strategy, this is probabilistic. Not every trade works, and some have to be cut - as per your HR being <1 (like the rest of us).  I refer you to post #35 and #37 of  "What has your hit and miss ration been?".  

As skc mentions above, lots of things can happen but rebal is expected to provide outperformance over time, with increased likelihood with the progression of time.  You are the house and offering Roulette.  Anything can happen over short intervals including, say, 12 reds in a row [which is akin to a two stock portfolio in which one stock moves up by 50% per annum for a couple of years and another moving down in a mirror fashion].  It is a real scenario, but the chances of occurring are slim. Over the longer term, the casino is ahead - as you also know and any path taken to get there is just one of many that chance might have allowed.

As a rough and ready tool to progress your thought experiment, let's BS and assume that stock returns are just random numbers.  Each stock return is an average return that you can set at your discretion +/- some random number.  So, say, we rebalance each quarter.  For quarter 1, say, Stock A has a return of 2.5% +/- 20%.  You can change these as you wish.  Produce a whatever-you-like (say, 5 years worth or 20 quarters) length of quarterly returns this way and you have our BS workbench approximation of a stock return.  Do the same for Stock B, C, D,...maybe to 20 stocks, heck go for 50 too if this is just an experiment.  These stocks can have different expected returns and different randomness around this expectation. So now you have our BS stock market.  You can create a stock market with all stocks going up, mixed or all stocks going down.  It doesn't matter, but you could do it if you wanted to.  What matters is that the random movements in the stock prices are not wholly synchronized....and that the expected stock price movement in either direction does not exceed the magnitude of the random part of the return for the whole period [ie. pulling Reds twenty times in a row for all stocks in your portfolio].  In other words, hopefully you'll see fit not to assume that all stock prices have an expected move of +/-10% per month if each random part is +/-10% (you can see the symmetry for other figures that you could use) in the same or different directions to infinity or zero if you are trying to get something out of this.  Or, you can do it with awareness of the remoteness of possibility. I'm not sure I have seen an equity market do 120% per annum ad infinitum.  Individual stocks might, though, and you might wish to play with this [movement size and time concentration] in a portfolio to see what happens.

Calculate two things...

1. Each quarter, average the returns across all 20 stocks.  These returns represent a rebalanced portfolio of equally weighted stocks.  It doesn't have to be equally weighted, and you can do whatever you like with the weights as long as it is consistent with 2.  Then accumulate these returns using compound returns.  That is your total return for a rebalanced portfolio over the period.

2.  Now, to calculate the return for an unbalanced buy-hold portfolio, you take the cumulative returns for each individual stock and average that.  This is the buy and hold return for an initially equally weighted portfolio.  Again, it doesn't have to start at equal weighting.  It just has to be consistent with 1.

Keep pressing F9 and you will find that the difference between 1. and 2. jumps around.  That's why it's called a probabilistic process.  Any one F9 press produces one scenario.  Anything can happen.  Count them and you will tend to find that, most of the time, 1. exceeds 2. by a healthy margin.  Keep records of it, and you'll probably find that the average difference is pretty interesting.  

Although this is a BS stock market, you can feel free to progress to use real stocks and try it out.  Just pick anything and give it a chance to play out over five years (it doesn't have to be five years...a longer period just helps you to see the conclusions more readily).  Try heaps of different combinations of real stocks, or just try a diversified portfolio of 50-100 truly randomly selected ones.  It would be helpful if you had a monkey to help you with this for authenticity.  The monkey can use a dart or can point.  In fact, they can do that at the end of each quarter and reshuffle the stocks (thus helping with the problem of high unemployment for primate stock selectors particularly in peripheral EZ), but keep the weighting schemes as they were, and that would be fine.  For the fun of it, get the monkey trained by NASA and get it to choose amongst the stocks that lost value over the investment horizon you are testing.  Choose any investment horizon over the period since stock markets were created.

Because it was a thought experiment, I imagine you don't really think in terms of two stock portfolios that move around by 50% amounts.  If you are rebalancing quarterly, say, movements of 50% in opposing directions in a two stock portfolio are...remote. And you have found that it does not subtract value in your experiment.

We then come to two hoary issues:
1. What about commissions and taxes?
2. But...I have views on the market, does this override this?

1. Please feel free to model your commission for trades.  In reality, you'd only rebalance significant outliers - say the 10 biggest misweighted positions each quarter as a rule of thumb. The small misweights don't matter much at all because they are...small. However, if your account size is small, commissions will be an issue.  In that case, rebal works pretty well on annual periods.  Go ahead and try it out (you already did, actually).  So there are always ways to bring comm into small consideration.  DO NOT cross the spread.  These are non-urgent orders and you can just sit on the limit order book until someone comes to you for liquidity.

Taxes are interesting.  If you are in pension mode, there's no issue.  If in SMSF accumulation mode, then the worst case cap gain is 15%.  Now check out what realistic turnover is and you'll find that it isn't much. It's all fractional stuff. Nothing like Martingale where you have to lay down exponentially larger bets as the market moves against you.   Factor in the fact that you are accumulating investments...which means that you are buying at current prices and have fresh parcels.  You are free to choose which tax parcels to liquidate.  Hence, you just choose the most expensive, subject to the applicable tax rate to the parcel.  When you allow for this and the fact that you are probably recycling dividends back into the market as well, you can generate more than adequate turnover without much cost in just about any scenario you wish to explore.  When you move to max tax rate, and you are accumulating assets, then fairly similar things apply as per the SMSF accumulation.  You generlally have enough room, or create enough room in your tax parcels for it not to be too much of an impediment.  Given you are smart, if you found that there was a line or so that was 'locked' due to heavy tax implications for parcel harvesting then guess what...just leave them out.  Things just aren't that sensitive to this stuff.

2.  Does this mean that you can't express a view?  WTF?  Of course you can.  Those simulations above are for an equally weighted portfolio.  There's nothing stopping that from being any weighting scheme you want.  Those weighting schemes are essentially your target weights in your portfolio.  However they were derived - it doesn't matter.  If you want to get a bit super-duper about it, then I refer you to Post #55  in "What has your hit and miss ration been?".  It will explain the key concepts and roughing it will for your needs is just fine.

Overall it's just cream on the cake.  But we are here to get phat.

Good trading to you, So_Cynical.


----------



## brty (29 April 2014)

RY,



> You are free to choose which tax parcels to liquidate.




Perhaps you don't understand the tax rules. From the ATO when you sell a parcel of shares they are considered to be the last ones you bought, you don't get to choose.


----------



## So_Cynical (29 April 2014)

DeepState said:


> Hi So_Cynical.  In terms of the basics of your thought experiment, no you did not miss anything.




Thanks for the reply, i don't often read long posts but you do write very well, even if im still very sceptical.

------------



brty said:


> RY,
> Perhaps you don't understand the tax rules. From the ATO when you sell a parcel of shares they are considered to be the last ones you bought, you don't get to choose.




We have been over this, you do get to choose.


----------



## craft (29 April 2014)

brty said:


> RY,
> 
> 
> 
> Perhaps you don't understand the tax rules. From the ATO when you sell a parcel of shares they are considered to be the last ones you bought, you don't get to choose.




BRTY - That is completely wrong.

If you are holding shares on a capital account (ie investor) you definitely get to choose and if you hold on revenue account as trading stock  (ie trading as a business) then LIFO is actually the one method that is deemed not acceptable if you don't want to uniquely identify the lots


----------



## DeepState (29 April 2014)

brty said:


> 1. The $2500 gain on ABC in the first year is taxable, so at the 30% tax rate thats $750, plus 2 lots of transaction fees extra. Net result, worse off with rebalancing.
> 
> 2. See what happens to your 2 stock portfolio if ABC goes up 50%/a for 5 years and XYZ goes down 50%/a for 5 years. That's when you see the risk of rebalancing.




1. You have missed something too. 

XYZ is down $2500 in the first year and thus has a tax asset in the form of an embedded capital loss.  This happens equal $750 providing an offset and the tax bill would be zero.  Harvesting this tax asset costs $40 and the repurchase leg would include the rebalancing element.  Total trading expense = $60.  This is 0.6% of the asset base in this thought experiment for a very small $10k portfolio.  Realistic rebalanced portfolios that have an annual rebal program have positive expectancy which exceeds this in the real world.  This concept would apply to larger portfolios which would result in proportionately smaller commission load.  It is also sensible for rebal to occur at the time when other portfolio activity is taking place.  Hence this commission load is actually shared with trades in alignment with proprietary insight and would be smaller than reported above.

2. Sure. Certainly a valid scenario.  Ouch. 

Now, in the history of mankind, please list the names of stocks in any exchange whatsoever that have gone up 50%pa (or more) for five _consecutive_ years and those which have gone down by 50%pa (or more) for five _consecutive_ years. Then, when you have achieved than feat, please list the number of two-stock portfolios involving this list that could have been built - remembering that these results have to occur _simultaneously_. Then divide this by the number of two stock portfolios that could actually have been built at any time in the history of mankind for a period of five years. Just today, there are much more than 40 million such portfolios that could be built.  That would be the probability of this scenario happening based on a grounded examination of history.

For this scenario to make any sense, a probability needs to be attached. Alternatively I could say "In the scenario where a Mars rover returned to earth spontaneously and stole my portfolio by hacking into my custodian records, rebal will do worse (actually it would match, but you might get the point)".  There is no skill in inventing arbitrarily extreme scenarios without likelihood. What is that probability? How many zeros would there be behind the decimal point before you reached a figure other than zero?  Ten? Twenty? Thirty? More...actually.  This figure would approximate the likelihood of the Mars rover portfolio theft scenario to at least 30 steps behind the decimal point. Is that risky? Should we be scared? An asteroid strike landing on your house in the next year is a greater risk.


----------



## DeepState (29 April 2014)

So_Cynical said:


> Thanks for the reply, i don't often read long posts but you do write very well, even if im still very sceptical.
> .




It's totally cool to be skeptical.  You opened your mind and considered it.  We take our paths from there.

Good trading to you So_Cynical


----------



## ROE (29 April 2014)

brty said:


> RY,
> 
> 
> 
> Perhaps you don't understand the tax rules. From the ATO when you sell a parcel of shares they are considered to be the last ones you bought, you don't get to choose.




I am with Craft, you got this wrong as an investor you can chose which parcel of share to sell as long as you got proof when you bought it ...fairly easy with equity as you got buy and sell contracts issue to you by the brokers.

ATO link here explaining it

https://www.ato.gov.au/General/Capi...entifying-when-shares-or-units-were-acquired/


----------



## brty (30 April 2014)

You are all talking about cap gain I believe. Yet my accountant has used LIFO for trading parcels (which we maybe discussing in rebal (if less than a year).

This on the ATO website



> For the purpose of the holding period rule, if a shareholder purchases substantially identical shares in a company over a period of time, the holding period rule uses the ‘last in first out’ method to identify which shares will pass the holding period rule.




from here...

https://www.ato.gov.au/Print-publications/You-and-your-shares-2012-13/?page=11

This is in regard to franking credits, but I have been informed for short term trading as well (the trading stock is identical without specific identification), or should I say my tax has been based on this. 
If different, I stand corrected. Can someone point me to something to show the accountant, please?


----------



## brty (30 April 2014)

RY,

In this country I have only been able to claim a capital loss upon realisation, you can't claim an open loss against a closed gain. Where can you do that? 

The point of doing the exercise with stocks that retreat by 50% per year is to see the weakness of rebal in an even portfolio (as in equal percentage of each stock)  , as you originally were discussing. If stocks go down 50%40%20%60%30% then to zero, you are stuffed. In a 2 stock portfolio B+H, if one wins and the other goes to 0, you can still make money. 
Put CFU in a 2 stock rebalanced portfolio over the last decade and see how you go compared to someone that just bought an equal share of 2 stocks, and just held. Any stock with it will do.


----------



## craft (30 April 2014)

brty said:


> You are all talking about cap gain I believe. Yet my accountant has used LIFO for trading parcels (which we maybe discussing in rebal (if less than a year).
> 
> This on the ATO website
> 
> ...





That use of LIFO in that situation is only to stop people avoiding the holding credit rules.

Sack your accountant.

http://law.ato.gov.au/atolaw/view.htm?docid=TXR/TR964/NAT/ATO/00001


----------



## McLovin (30 April 2014)

brty said:


> RY,
> 
> In this country I have only been able to claim a capital loss upon realisation, you can't claim an open loss against a closed gain. Where can you do that?




If you classify your shares as trading stock (which it sounds like your accountant is doing) then you can get a deduction on unrealised losses.

Of course that wouldn't actually be a "capital" loss but you get the picture.


----------



## ROE (30 April 2014)

You don't need your accountant a software like topshare will do a better job
At calculating your CG..

When you sell a parcel of shares you tick minimise capital gain
And it works out the best parcel of share to sell.

If there is a parcel that can be sell at a loss to offset capital gain it will do that for you
Or it can take 200 shares from this parcel or 300 shares from this parcel
etc....


----------



## Ves (30 April 2014)

DeepState said:


> 1. You have missed something too.
> 
> XYZ is down $2500 in the first year and thus has a tax asset in the form of an embedded capital loss.  This happens equal $750 providing an offset and the tax bill would be zero.  *Harvesting this tax asset* costs $40 and the repurchase leg would include the rebalancing element.  Total trading expense = $60.  This is 0.6% of the asset base in this thought experiment for a very small $10k portfolio.



I understand that in this scenario you are referring to the fact that you can sell the parcel to realise the tax loss,  and then repurchase an identical parcel on the market.  In effect offsetting any gains made in rebalancing the  parcel that was profitable.

If this is what you are doing,  then I would be vary wary of doing this in practice.   The ATO has not be too kind in  recent years when considering any such schemes that have no other purpose than to derive a tax benefit.  Especially when identical or similar parcels are repurchased very soon after the original sale (ie.  your economic interest remains similar before and after the fact).

The resetting of cost bases to "harvest capital gains" has been raised by the ATO as a Division IVA target.

The practice is commonly called a "wash sale"  or "tax loss selling."

Fairly sure that the relevant tax ruling is TR 2008/1.

http://law.ato.gov.au/atolaw/view.htm?DocID=TXR/TR20081/NAT/ATO/00001&PiT=99991231235958

It may or may not apply to your circumstances,  but you should definitely consider it.


----------



## DeepState (1 May 2014)

Ves said:


> I understand that in this scenario you are referring to the fact that you can sell the parcel to realise the tax loss,  and then repurchase an identical parcel on the market.  In effect offsetting any gains made in rebalancing the  parcel that was profitable.
> 
> If this is what you are doing,  then I would be vary wary of doing this in practice.   The ATO has not be too kind in  recent years when considering any such schemes that have no other purpose than to derive a tax benefit.  Especially when identical or similar parcels are repurchased very soon after the original sale (ie.  your economic interest remains similar before and after the fact).
> 
> ...




THIS IS NOT TAX ADVICE.

Hi Ves, 

Wash sales refer to transactions which take place "within a short period of time of each other" (Paragraph 2).

Please refer to Example 2, Paragraph 28.  As an example, the ATO has provided an indication of what they think is short.  This is illustrated as a day.

This stuff is not sensitive to urgent trading at all and you can take economic risk as required and intended by the ruling.  


Disclaimer: None of the above is an effort to constitute tax advice for anyone reading or otherwise in receipt of details in this post.  I am not a tax adviser.  Please seek advice from your own adviser.


----------



## Ves (1 May 2014)

DeepState said:


> Wash sales refer to transactions which take place "within a short period of time of each other" (Paragraph 2).
> 
> Please refer to Example 2, Paragraph 28.  As an example, the ATO has provided an indication of what they think is short.  This is illustrated as a day.
> 
> This stuff is not sensitive to urgent trading at all and you can take economic risk as required and intended by the ruling.



Of course you can reduce or take on additional economic risk   (however, that may also detract from some of the "edge" of the process in itself).

In the ATO ruling Example 6 is probably more important than Example 2.     "short period of time" is not defined,   the ruling only shows that they consider one day is a "short period of time."  Just because they do not say that anything longer than a day is OK,  does not always make it so.

Example 6 shows what you mean about economic risk,   and also infers that you might need to provide evidence or reasoning behind your buy or sell decision.  Otherwise it is pretty hard to argue that you did not sell then repurchase to avoid a tax liability.   Interestingly the time frame is this example is also longer....   and they are fairly silent on this factor.   Hint hint.

So if I'm doing this,   and my strategy,  after vigorous research and analysis is to rebalance quarterly,  but I don't want to pay any more tax in doing so,   and do not want to take on (or reduce) unnecessary economic risk by sitting out of the market in one of my holdings, what do I do?  I'm here to make money,   not risk it by pissing the tax man off.


----------



## DeepState (1 May 2014)

Ves said:


> Of course you can reduce or take on additional economic risk   (however, that may also detract from some of the "edge" of the process in itself).
> 
> In the ATO ruling Example 6 is probably more important than Example 2.     "short period of time" is not defined,   the ruling only shows that they consider one day is a "short period of time."  Just because they do not say that anything longer than a day is OK,  does not always make it so.
> 
> ...




Hi Ves

Very sharp.  You are right to manage your own concept of tax risk. And, you keep surprising on the upside. I am maximum long VES-AU.

Here are some thoughts.  They do not constitute tax advice.  They are just thoughts.

Example six refers to a time period of 3 days between sale and purchase.  Example 2 refers to 1 day.  Basically short is pretty short. In the two opportunities they had to provide examples, we get this.  

Wash sales are particularly dominant in the months leading up to financial year end where sales take place on 30 June or the week prior only to be repurchased in early July. You can actually see it in the security prices and, to an extent, predict it.  Also we're not talking like many weeks.  

Part IVA also refers to a "predominant" reason and hence this also has to be balanced against economic risk.  In the list of 8 considerations, they basically boil down to being out of the market (not switching the exposure by various mechanisms like family transfers, hedging or whatever) so you are devoid of economic exposure to the asset; and the period of time that this occurs in.  The examples provided are for very short periods of time.  But, as for just about everything in tax and law, they offer nothing explicit in terms of guidance and the case law develops as the boundaries are discovered.  Words like 'substantively' and 'predominantly' are used.  The Commissioner will 'give regard to' the time between sale and repurchase.  Obviously stuff done overnight is at risk.  And the risk declines from there.  Everything we do is like this, except that a pattern of case law develops and people get the hint and back off - mostly.  Further, any trading activity would be at risk for the same reasons.

There is a tax law for S177EA which relates to franking credits.  These are subject to some of the harshest tax laws that can be found.  For illustration, the Part IVA requirements look at 'predominant purpose' of an activity. To receive franking credits, they must be an 'incidental purpose'.  In other words, you can't even think of them, but if they turn up...great.  That is the literal translation!  Yeah, we were shocked too. Taken to it's literal meaning, any thought to tilt your portfolio towards franked dividends because you are in SMSF accumulation or pension actually contravenes S177EA because you did it for more than an incidental purpose!  And what about all those Imputation Funds?   Remember, this is a very high priority for the ATO. Yet you don't see penioners getting dragged in for thinking about after tax yield. In any case, the Section requires to you be at risk (30% economic exposure and time of strategy initiation) for 45 days around a franking credit entitlement to receive it.  This is much harsher than Part IVA, but at least provides guidance about the boundaries.

Hence the ATO has expressed say, unacceptable wash sale, at something like a week (7 days vs their longest example of 3).  Their harshest rules relating to franking require 30% economic exposure for 45 days.  This is sort of the same as two weeks at full exposure...just to provide a boundary of being economically at risk by ATO reckoning.  Let's say we want to be 'really safe' and double that horizon to a month.  In that time, any concept of economic risk that we can glean is acceptable from ATO S177EA is exceeded.

I don't know the case law for Part IVA, but I'll be very surprised if economic exposure of a month or more would be contested.  Please let me know otherwise.  Your tax agents should also know.  I am not a tax expert or registered tax practitioner.  I'm just reading what's in front of me - kind of like you.  Also, back in the day, we sought and received tax advice from a major firm and then others in rotation relating to how we traded our portfolios in light of the release of this ruling in 2008. It indicated that we should steer clear of reversals unless for strong reasons like hedging newly developed risks.  But they felt it safe to reverse positions in a period that was (quite a bit) less than a month.  We were also subject to having to explain positions reversed for less than a week.  That just gives you an idea of what the practice was.  We never had an issue.  That practice was never revised.

In other words, being out of the market for a month constitutes, for all practical purposes, sufficient economic risk to satisfy Part IVA.  

So, does being out of the market for a stock matter much? Sticking to this 2 stock example, you'd have 25% out of the market for a month.  If the market average return is 10% per annum and 'normal' cash rates are 4%, that means we can expect to forego 6%pa return for 25% of the portfolio...that would be 0.125% (pre-tax).  And then you hold the stock for the remaining two months.

Now, does rebal - in isolation - get affected much? We've already allowed for the expected cost for being out of the market.  What matters is that the stocks are volatile and that they are lowly correlated.  All things equal, being out of the market for one month out of three reduces volatility by about 20% proportionately.  Is you rebalanced six monthly, this figure is about 10%.  That's not good for re-bal.  However, the correlations fall to offset. The trade ff between them will depend on the nature of the relationship between and within each stock.

All this is total BS of course.  BS ALERT!!! You'd never do it (creating economic risk buffers) sustainably unless you had sophisticated stuff and really wanted to spend time calculating and scheduling rebal time.  You could, however, do it once in this scenario.  My main purpose in pointing this out was to highlight that if you paid tax and rightfully declare it as a burden on your returns, it is also reasonable to outline that you have created a tax asset as well.  This is a practice enshrined in accounting standards and professional investment performance presentation standards.

Getting back to reality, the real way you'd do this in a real-life situation that avoids all the ATO tax stuff is to pay your tax bill out of cash reserves.  Thus, your expected potentiality will decline by the after tax return on the amount of cash you need to pony up to pay for the realized gain.  Assuming you have a cash account for 4% and the tax rate is per BRTY's 30%, then that figure is $750 x 0.04 x (1-0.3) = $21.  Hence your expected return is reduced by 0.21%.  This tax asset can be expected to be harvested - this time without too much concern for ATO transgression - as the market rises and turnover occurs.  Not too shabby.

Some things to consider:  

The scenario put up by So_Cynical is obviously extreme for the purposes of a thought experiment.  Big moves in opposite directions.  That's about the worst case scenario that you can reasonably paint for these purposes although even worse outcomes are clearly possible.  So the drag from cash, which will span a range depending on market conditions, is likely to be much smaller and eventually disappear if you believe in the equity risk premium at all.  If you think equities will flat line forever, what are you doing in them at all?

Rebal is, for most, going to be a layer on top of an actively managed portfolio.  In scenarios where re-bal happens to be highly synchronized with your trading, it could make it worse.  But this is really a theoretical anomaly that I'm just putting out there. For symmetry, rebal might be negatively correlated with your active strategy and reduce tax drag.  If you run the portfolio as pure re-bal then all of the drag is obviously attributable to re-bal. 

In the situation where you get more gains and are turning them over, re-ball will be harvesting CGT.  But the reality is that most accounts would be turned over anyway so additional turnover won't do a heck of a lot.  The thread has also discussed how cash flow and reinvestment of dividends helps to reduce the tax cost of turnover.  

Great pick up.  

Cheers


----------



## sinner (1 May 2014)

Yep, it works, always. Whether it outperforms is completely up to the current market regime.

See here:

http://cssanalytics.wordpress.com/2...et-allocation-lessons-from-perold-and-sharpe/

and if you want the academic explanation see here:

http://www.stanford.edu/class/msande348/papers/PeroldSharpe.pdf


----------



## craft (2 May 2014)

I don’t see the tax issue as important in relation to re-balance even if you don’t do anything to realise any tax loses for balancing up the tax bill.  End of the day we are only talking timing difference – not paying more CGT (and if we are paying more CGT in total it just means re-balance has worked).

As a long term holder I understand the unrealised tax liability can be a significant interest free loan, but I don’t see tinkering to re-balance really impacting its quantum that much especially when a lot of the rebalancing can be achieved by the dividend stream.

Now I don’t personally rebalance based solely on market price but I am continuously rebalancing based on my perception of value vs market price, by re-investing the dividend stream and if the opportunity gets large enough through capital transactions as well.


----------



## Ves (2 May 2014)

DeepState said:


> Here are some thoughts.  They do not constitute tax advice.  They are just thoughts.




Thanks RY,   it is always nice to hear how things actually work in practice  (ie.  what some of the bigger firms do to avoid running foul of the tax office).

It's a bit of a grey area... but if you are aware of it,  it is probably not a massive restriction on rebalancing in most cases.

I also agree that this would only be an issue in extreme cases,   and as craft said,  the tax liabilities in effect smooth out over the a very long time frame (the only difference is timing).

The ATO's pet play,  funnily enough that you should mention franking credits,  is "dividend washing" at the moment.   It is (probably) unrelated to rebalancing,  but it is interesting in the fact of how they communicated the issue,  and how their actual enforcement of it varied   (ie.  initially they inferred that they would target it from 1 July 2014,  however in the end they sent letters to investors who were suspected to have used "dividend washing" before this date and gave them the change to 'fess up).  The ATO is often a strange beast.

Sorry to side-track the discussion.


----------



## DeepState (2 May 2014)

Ves said:


> Thanks RY,   it is always nice to hear how things actually work in practice  (ie.  what some of the bigger firms do to avoid running foul of the tax office).
> 
> It's a bit of a grey area... but if you are aware of it,  it is probably not a massive restriction on rebalancing in most cases.
> 
> ...




Sorry to keep side-tracking...

How is it that you are so sharp on this?  Others are too.  I only knew this stuff because our L&C people dragged me into meetings with Tax Partners who looked at me sternly so I was led to believe they were actually serious whilst charging out $1,000 per hour or something and laughing on the inside.  My knowledge is going to decay...how are you keeping up with it all? 

Let me know if you want the stories on how the rules came to being.

Yeah, that div washing stuff is all linked to options creating a cum-div market for a few days around ex-div as calls are exercised.  And then the hole was found and exploited.   I would never have dared do this sytematically.  But across the line for the ATO and way beyond the intent of the Act and any conceivable concept of 'incidental purpose'.  Took years for the crackdown to occur.  It's just an example of how much you can push the law beyond what is written before the ATO bites. 

Cheers


----------



## Ves (2 May 2014)

DeepState said:


> How is it that you are so sharp on this?




I know of a lot of these rules from my work.   I work as a tax accountant / administrator for SMSFs.  Not high up or anything,  but I keep an eye out for any ATO updates.  Read enough of them,  and you begin to know where to look.    I'm no expert,  but find that discussing some of these things enhances my knowledge.



> Yeah, that div washing stuff is all linked to options creating a cum-div market for a few days around ex-div as calls are exercised.  And then the hole was found and exploited.   I would never have dared do this sytematically.  But across the line for the ATO and way beyond the intent of the Act and any conceivable concept of 'incidental purpose'.  Took years for the crackdown to occur.  It's just an example of how much you can push the law beyond what is written before the ATO bites.
> 
> Cheers



As far as I know,   the secondary market for "cum div" stocks was set up by the ASX to allow foreign investors who could not claim the franking credits because they were not Australian residents.

Of course,  others saw an opportunity in this.   The ATO is often slow with this stuff as you said,  but when they catch wind,   the door gets jammed shut pretty quickly.


----------



## Rubberneckin (15 July 2014)

brty said:


> TPI,
> 
> Rebalancing, from some limited research, within the category of shares, will only work with a group of shares going up in price.
> 
> ...





I can see why this might be a problem if you own individual company shares, but what if you choose from a population of say a dozen uncorrelated ETF's and only selected say the top 3 or 4 based on their relative strength, re-balancing on a monthly basis?


----------



## brty (16 July 2014)

Rebalancing on a monthly basis is not going to work as the combination of slippage and commissions is going to kill any slight gain.
With a large enough portfolio, rebalanced yearly, should give some minor out performance. I had a brief look at ARG and AFI over about a 15 year period. What I noticed was one would out perform the other for a number of years, then it was the other ones turn. Instead of time based redistribution, in this case it looked like percentage under/over performance was the time to rebalance (by eyeballing the price graphs together).
However, it still looks like the CODB would eat most of any minor gain.
For instance, if you wanted to sell 6,000 ARG and buy 7,000 AFI to rebalance, just buying at the ask and selling at the bid reduces the gain, assuming there is enough on offer close enough. If you 'wait' for your orders to be hit, one will go off while the other sits, suddenly your open to market risk with only one of the transactions taking place.
And before some-one jumps in being all knowing,I know they are LICs and not ETFs but the principle is the same. Then again ETFs that are weighted to different sectors of the market shouldbe worth studying, off you go


----------

