When you think about investing, you have a very long decision tree — the question of passive or active, long or short, stocks or funds, gold or cryptocurrencies and on and on. These topics seem to occupy the majority of the media's attention as well as individuals' minds.
However, these decisions are far down the investing process relative to portfolio management. Portfolio management is basically looking at the big picture. This is the classic forest-and-trees analogy — many investors spend too much time looking at each tree (stock, fund, bond, etc.) and not enough (if any) time looking at the forest.
Prudent portfolio management begins after the client and his or her advisor have reviewed the total picture and completed an investment policy statement (IPS). Embedded in the IPS is an asset allocation strategy such as integrated, strategic, tactical and insured.
Most people recognize how critical asset allocation is, but most investors are unfamiliar with asset allocation rebalancing strategies, including buy-and-hold, constant-mix, constant-proportion and option-based. A lack of familiarity with rebalancing strategies helps explain why many confuse the constant-mix rebalancing strategy with buy-and-hold.
Here is a side-by-side comparison of two well-known asset allocation rebalancing strategies.
How Buy-and-Hold Rebalancing Works
The objective of buy-and-hold is to buy the initial allocation mix and then hold it indefinitely, without rebalancing, regardless of performance. There are a variety of ways to find buy-and-hold stocks. The asset allocation is allowed to vary significantly from the starting allocation as risky assets, such as stocks, increase or decrease.
Buy-and-hold is essentially a "do not rebalance" strategy, while acting as a truly passive one. The portfolio becomes more aggressive as stocks rise and you let the profits ride, no matter how high the stock value gets. The portfolio becomes more defensive as stocks fall and you let the bond position become a greater percentage of the account. At some point, the value of the stocks could reach zero, leaving only bonds in the account.
How Constant-Mix Investing Works
The objective of constant-mix is to maintain a ratio of different asset classes (for example, 60 percent stocks and 40 percent bonds), within a specified range by rebalancing. You are forced to buy securities when their prices are falling and sell securities when they are rising relative to each other.
Constant-mix strategy takes a contrarian view to maintaining a desired mix of assets, regardless of the amount of wealth you have. You are essentially buying low and selling high — as you sell the best performers to buy the worst performers. Constant-mix becomes more aggressive as stocks fall and more defensive as stocks rise.
Buy-and-Hold vs. Constant-Mix in Trending Markets
The buy-and-hold rebalancing strategy outperforms the constant-mix strategy during periods when the stock market is in a long, trending market such as the 2010s. Buy-and-hold maintains more upside because the equity ratio increases as the stock markets increase. Alternately, constant-mix has less upside because it continues to sell risky assets in an increasing market and less downside protection because it buys stocks as they fall.
Figure 1 shows the return profiles between the two strategies during a long bull and a long bear market. Each portfolio began at a market value of 1,000 and an initial allocation of 60 percent stocks and 40 percent bonds. From this figure, you can see that buy-and-hold provided superior upside opportunity as well as downside protection.
Figure 1: Buy-and-hold vs. constant-mix rebalancing
Buy-and-Hold vs. Constant-Mix in Oscillating Markets
However, there are very few periods that can be described as long-trending. More often than not, the markets are described as oscillating. The constant-mix rebalancing strategy outperforms buy-and-hold during these up and down moves. Constant-mix rebalances during market volatility, buying on the dips as well as selling on the rallies.
Figure 2 shows the return characteristics of a constant-mix and buy-and-hold rebalancing strategy, each starting with 60 percent stocks and 40 percent bonds at Point 1. When the stock market drops, we see both portfolios move to Point 2, at which point our constant-mix portfolio sells bonds and buys stocks to maintain the correct ratio. Our buy-and-hold portfolio does nothing.
Now, if the stock market rallies back to initial value, we see that our buy-and-hold portfolio goes to Point 3 (its initial value), but our constant-mix portfolio now moves higher to Point 4, outperforming buy-and-hold and surpassing its initial value. Alternatively, if the stock market falls again, we see that buy-and-hold moves to Point 5 and outperforms constant-mix at Point 6.
The Bottom Line
Most professionals working with retirement planning clients follow the constant-mix rebalancing strategy. Meanwhile, most of the general investing public has no rebalancing strategy or follows buy-and-hold out of default rather than a conscious portfolio management strategy. Regardless of the strategy you use, in difficult economic times, you will often hear the mantra "stick to the plan," which is preceded by "be sure you have a good plan." A clearly defined rebalancing strategy is a critical component of portfolio management.