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The normal thinking would have us believing that a bubble is a dangerous situation for our retirement accounts. What if I told you that I believe a market bubble makes your portfolio more resilient? Would you believe me?
Everyone fears bubbles. You should harvest them.
Don’t worry, I haven’t lost the plot, let me be clear: I’m being deliberately provocative to make a point about something some investors neglect when things are going splendidly well, disciplined rebalancing. In reality, bubbles are only devastating if you lack a system. With the right approach, they can actually strengthen your portfolio.
I have some caveats to qualify my contention, although they are actions you should, as a responsible investor, already be practicing.
Rule one. Don’t be greedy and lose track of your investment statement.
Rule two. Rebalance your inflated equity position back to your proper asset allocation.
Rule three. When the bubble bursts, draw from your cash and bond positions.
That’s all you need to do. Rule one forces you to rebalance, rule two forces your allocation back to your statement allocation and indirectly increases the size of your safe assets. Rule three stops you from selling distressed equities.
Let me show you what this looks like in practice. Say you start with a $1,000,000 portfolio split 60/40 between stocks and bonds. This means you have $600,000 in stocks and $400,000 in bonds.A bubble inflates your equities by 50%, growing your stocks to $900,000 while your bonds stay stable at $400,000. Your total portfolio is now $1,300,000. You now have a risky 69/31 split.Most investors, your neighbor, for instance, ride this wave, convinced they’re geniuses.
You rebalance.You sell $120,000 in stocks at bubble prices and use that cash to buy bonds. Your portfolio is now back to a 60/40 split, with $780,000 in stocks and $520,000 in bonds.
When the crash comes and stocks drop 40%: Your neighbor who didn’t rebalance loses $360,000 in equity value (on their $900,000 starting equity).You lose only $312,000 (on your $780,000 starting equity).
But here’s the magic of rebalancing, after the crash, your portfolio has $520,000 in bonds and cash to draw from while stocks recover. Your neighbor? They only have $400,000 in bonds. The neighbor could be forced to sell their remaining stocks at a loss to pay the bills. You, the rebalancer, sold high and now have a $120,000 bigger cash cushion to weather the storm and a reserve to buy back depressed equity.
The market will scream at you to stay greedy. Your neighbor will brag about gains. Rebalancing during bubbles feels like leaving a party early, but that’s exactly when you should. This is where some investors fail. The human greed to hold on, to capture just a bit more upside, is overwhelming. But discipline isn’t about feelings. It’s about the system.
This is what some people miss: volatility isn’t your enemy. Lack of discipline is. A bubble without rebalancing is catastrophic. A bubble with systematic rebalancing becomes a forced wealth transfer from your risk assets to your safe assets, at precisely the moment when risk assets are most expensive.
So the question isn’t whether bubbles are dangerous. It’s whether you have the discipline to profit from them. Do you feel lucky?
I do feel much less nervous after recently rebalancing by slicing about one-third off of the YTD increase in our growth equities to buy additional stable-value investments. And since this was done within an IRA there were no tax consequences. Perhaps will do a little more to bring the total slice up to about one-half of the YTD increase. Depends on how much of the increase is “bubble” and how much is real long-term investment growth. Only the future will tell.
Mark, this post ties in well with Bill Housley’s post, Your Portfolio, Your Business. Unless you invest in some type of balanced or target date fund, you need to be an active participant in minding your portfolio. The math you provide helps drive home the point.
Great title, by the way.
Not that active. Your investment plan should tell you when to rebalance – ideally once a year on a set date or when your asset allocation is off by 5% or more. Some people say to forget the once yearly rebalance and just use the 5% guardrails. Either way, minimal activity.
All joking aside. I feel it’s of paramount importance to be honest about your portfolio allocation. Balancing back regardless of market strength is vital to your future wealth.
The “make my day, punk” is a catchphrase from the Clint Eastwood movie Sudden Impact. Odd that I’ve seen that phrase used in another forum a few days ago.
Would you believe I always thought it was from Dirty Harry, but I just politely asked Mr Google and you’re correct. I’ve been laboring under a false assumption for the last 30 odd years lol.
Sudden Impact is the title of the fourth Dirty Harry movie.
Right. I think Clint was accompanied by two of his friends; Smith and Wesson.
The two most powerful friends in the world, apparently.
Excellent post Mark. As I recently posted since we are living off our assets until we claim Social Security at 70 I have been calculating our investment and net worth quarterly. My unwritten investment plan is to rebalance when my allocation is out of balance by 5%. At the end of this last quarter I was three percent over in equities and decided to rebalance and purchased bonds due to the goings on in congress, but even more so in the White House. With the drop in the market on Friday of 2 1/2% my portfolio only dropped a quarter of that so I was chill. Yesterday I already recovered about 75% of the Friday loss.
When we claim Social Security the majority if not all of our yearly expenditures and possibly more will be covered. At that point I will most likely gradually increase our equity stake to a, at this point, undetermined percentage. I will then switch and perform the calculations on a semiannual basis as our portfolio balance will be less of a factor in our income going forward.
I think rebalancing is a very good idea.
I can understand this if your investments are in tax preferred accounts, but how do you deal with the fact the selling of stocks triggers taxes that reduce your reinvestment?
Just thinking out loud here. In the long run, it may be cheaper to re-balance taxable accounts and pay long term capital gains, than to re-balance qualified accounts that will incur ordinary income tax in the future. Also, if both types of accounts will eventually be inherited, the beneficiaries will appreciate the step up in value in the non qualified money.
To me, the primary value of rebalancing is risk control. While selling an appreciated asset in a taxable account incurs a tax cost, that cost is a tax on a profit and is small compared to the potential economic loss from allowing your risk level to spiral out of control. By using your tax-advantaged accounts and new cash/dividend flows as your first lines of defense, you can minimize tax friction while maintaining portfolio discipline. A dangerous asset allocation far outweighs the cost of taxes paid to correct it.
Assuming that the investor has both brokerage and preferred an accounts the selling only occurs in the preferred account where there are no tax consequences. In my mind it would be highly unusual for an investor to have all their investments in just a brokerage account.
I guess, but you would have to have the right mix of investments in both accounts to make it work. A bit complicated I suspect.
Mark, thanks for another thought provoking article. For starters, I think that we agree pretty strongly, but this just gives me a chance to go on a bit of a rant. The “bubble” talk lately is all getting to me a bit.
I think that everyone needs to decide, and really to commit to, their particular strategy.
Either you are a long term investor that sets a strategy, including asset allocations, then just sticks to that.
Or you monitor current events, and try to shift your money based upon your reading of the current situation.
For me, the latter gets awfully close to market timing. I know that I am certainly not clever enough to win at that game. So I stick to the former – long term strategy that remains the same regardless of P/E ratios, AI data centre investment or whatever is happening at any point in time.
To each their own. But I will just be sticking with our well diversified index funds (no bonds or fixed interest), dollar cost averaging into them, and not getting concerned about the daily financial news.
“But I will just be sticking with our well diversified index funds (no bonds or fixed interest)” Greg. Does that mean you’re invested 100% equity?
Yep, pretty close. I just checked the holdings in our Vanguard index fund, and there is a small amount of fixed interest and bond exposure. Ideally we would like just 100% equities, but the bonds and fixed interest just happen to come with this particular Vanguard fund (and I’m not interested in making my own diversified portfolio with different index funds all pieced together – too lazy!).
We are completely comfortable with the volatility that equities bring. To my mind, volatilty does not equate to risk, unless you have a short time horizon. We have about 13 years until retirement, then I hope we might have 20-25 years beyond that . Across those timeframes, the volatility all just melts away.
As we get close to retirement we will probably pull about 3 years of living expenses into fixed interest so we can mitigate the risk of drawing down from a bear market. Apart from that, we will remain “all in”.
I agree completely. In my thirty years of investing for retirement and dozens of ups and downs/bubbles the lesson I’ve learned is not to try to time the market. I am not smart enough to know the future, but I do know that every time it goes down it goes back up.
I admit though that I also have more financial peace in retirement due to the fact that I have over 100% income replacement