Increase your return per unit of risk?

Why bother?

I wrote a post about an insidiously appealing – yet flawed – approach to investing promoted by the financial services industry (I wonder if high turnover helps them or hinders them?) called ‘re-balancing’ …

… even if it were sensible (it’s not), it requires an even more flawed base to sit upon: a diversified portfolio. Now that is something that the financial services industry makes money from! 🙂

That post inspired a discussion with Jeff, who provides some useful number-crunching to support his ultimate argument for rebalancing:

Consider two cases in the first you rebalance in the second you don’t:


Stocks Bonds Total Comment
50K 50K 100K Initial conditions
25K 50K 75K right after market crash
37.5K 37.5K 75K After rebalancing
75K 37.5K 112.5K Right after market recovery
56.25K 56.25K 112.5K After rebalancing

No Rebalancing:

Stocks Bonds Total Comment
50K 50K 100K Initial conditions
25K 50K 75K right after market crash
50K 50K 100K Right after market recovery

Note rebalancing earned an extra $12.5K over doing nothing, it doesn’t compare to perfect market timing but there was no crystal ball required! Jeff pointed out rebalancing maintains the risk level. Was it less risky to hold half stocks half bonds? Yes, in the 50% market crash there was only 25K in losses rather than a 50K loss.

What if the order was different?

Stocks Bonds Total Comment
50K 50K 100K Initial conditions
75K 50K 125K Market rises 50%
62.5K 62.5K 125K Rebalance
31.25K 62.5K 93.75K Market drops 50%
46.9K 46.9K 125K Rebalance

No Rebalancing:
Stocks Bonds Total Comment
50K 50K 100K Initial conditions
75K 50K 125K Market rises 50%
37.5K 50K 87.5K Market drops 50%

Again rebalancing helps prevent losses over doing nothing. If you are invested in more than one asset class you should rebalance.

So, it seems that rebalancing is inexorably tied to diversification: do one and you should do the other, but what of the reverse?

Let’s turn again to Jeff [AJC: I cut/pasted a couple of Jeff’s comments … you can read the entire thread in its original form here] , who says:

If you have elected to diversify your portfolio I would argue that you should rebalance to maintain your initial asset class mix.

You add bonds to your portfolio to reduce risk. Failing to rebalance increases the your risk as time goes on…which is typically the opposite of what most investors desire. The reason you do this is not to maximize return, but to maintain the same risk that you had when you started.

The real reason people diversify into higher risk asset classes is to increase their return per unit of risk. Even when a higher risk asset class increases the overall risk of your portfolio, the excess return is disproportionately large when compared to the excess risk. Thus, overall the return per unit of risk increases, helping you to maximize the amount of return you receive for the risk that you take on.

Rather than focusing on return per unit of risk, shouldn’t we look at risk per unit of required return?

Surely we should:

1. FIRST look at what RETURN we need in order to achieve a required financial goal, and

2. THEN compare the risk-profile of the various choices that can produce the desired return or better (hence, required annual compound growth rate) NEEDED to get us there, and

3. USE THAT menu of qualifying investments to make our investment selection from?

If your financial goal – e.g. Your Number – is sufficiently large and/or your desired timeline – e.g Your Date – sufficiently soon, diversifying/rebalancing may be among the highest risk options available, along with any other investment strategy that fails to meet your required annual compound growth rate!

Diversification/Rebalancing simply may not return a high enough amount to fuel the annual compound growth rate required to get you there!

In which case, you only have some combination of the following three choices:

i) Reduce your Number, and/or

ii) Extend your Date, and/or

iii) Accept a higher level of technical risk in your investment choice/s

But, is there a point in life when it makes sense to switch to a risk-above-return strategy?


As Jeff says:

As I get older I will be increasing the % of bonds that I hold and will be rebalancing.

But, I would not (first) look at my age … again, I would first tie this to my financial goal i.e. my Number:

When I reach my Number (or, if I fail and am within 7 years of my latest retirement age), I would shift to a Making Money 301 Wealth Preservation Strategy, such as:

1. That promoted by Prof. Zvi Bodie (Worry Free Investing) – putting 95% – 100% of my Investment Net Worth into Treasury Inflation Protected Securities (TIPS) and the remainder (0% – 5%) into call Options over the S&P 500, or

2. That promoted by Paul Grangaard (The Grangaard Strategy) – putting 70% of my Investment Net Worth into a low cost S&P 500 Stock Index Fund and 30% into a bond-laddering strategy to cover my anticipated spending for the next 5 years (then ‘repeat’ every 5 years), or

3. Putting 80% of my Investment Net Worth into positive cashflow (before tax) real-estate (I would ‘jiggle’ my deposit amount to ensure at least a 6.5% return p.a.) and keeping 20% in cash and CD’s as a buffer against vacancies, repairs and maintenance, taxes, etc.

4. If all else failed, or as a ‘last ditch’ effort to avoid leaving too much in cash/bonds, a diversified portfolio of stocks and bonds … possibly to be rebalanced each year.

But, the last word goes to Jeff:

This, of course, doesn’t mean anything unless the new return is something that you desire.

Indeed 😉