The Full Motley -- 2Q, 2016

Like it or not, it is time for another quarterly update!

I have said a lot about periodic rebalancing over the years (February 2016 marked the seventh year of this blog, albeit I missed that update due to work volumes from two jobs), but the most consistent things that I have said about its merits is that it is the most practical method to employ "buy low/sell high" methodology and that it is the most effective method to remove emotions from investing (hence my minimalist pun in the first paragraph).

The amounts being shifted each quarter are insignificantly low, typically between 1-2% of the overall portfolio. But the more telling aspect is often which fund(s) had the most movement in any given quarter. I have not missed (m)any quarterly reallocations (even if I do not write out an actual update) so each quarter, the funds begin at their intended percentage; therefore, any deviation is the result of its relative performance. This quarter, the two biggest movers were Vanguard Explorer Fund (up) and Vanguard Total International Stock Index Fund (down). Not many other sectors moved over the past three months (which are inconveniently in the middle of each quarter), which is only noteworthy insomuch that I was surprised to see the bond market index hold its own.

To the uninitiated, it would appear as though rebalancing (even the "buy low/sell high" mantra itself) would "punish winners" and "reward losers," and it would if the stock market had absolute winners and absolute losers. American culture is very competitive, so the instinct to identify winners and losers is ingrained in our minds so heavily that it feels innate. However, the opposite of competition is cooperation, and that is in fact what the allocation is in the first place. These funds are working together within the same portfolio on the basis that each year is going to be different than the past. Some years, certain assets will perform better than the high performers of yesteryear.

Understand that there are two key elements involved herein though. The first is that the investments within the portfolio are broadly diversified within an asset class and, secondly, that the asset classes are viable sectors for future years. Using the past for example, it would not make sense to invest in telephone companies after the explosion in cellphones (that is, unless the company were positioned correctly to hold its own as the paradigm shifted). Cable companies would be a dangerous asset class today if they're a pure-play cable without exposure to delivering the Internet or other streaming services to its consumers. Conversely, bonds are poised for a sharp decline -- and they have been for a number of years, which we have yet to see -- but even if the market collapsed, bonds are still viable investments thereafter so a sharp recovery could be expected. As the market declined, investors who rebalance periodically would be directing money in the asset class, so when a recovery occurred, they would have purchased a considerable amount when the assets were deflated, which reaps immediate benefits from having a lower cost average per share.

There Is No King

With all due respect to Maria, how do you solve a problem like TINA? Because "she" is becoming a problem.

From a 5% return to nothing seemingly overnight.

If pictures are worth a thousand words, then the chart of the 10-year return on a hypothetical $10,000 in Vanguard Prime Money Market Fund should say it all. In 2006 and 2007, the fund was returning a generous 5% APR. In the eight following years, the fund earned less than 0.3% APR. In other words, stashing money under the mattress or burying in the front lawn legitimately may have had a better risk-adjusted return!

The Federal Reserve Bank (the "Fed") has kept its federal funds rate significantly less than 1% since December 2008. At that time, investors were so frightened by the markets that financial stability was its own incentive, so the funds did not need to offer a corresponding interest rate (because 0% APR is higher than any loss).

Consequently, the Fed left investors with no choice but to invest in stocks. As the markets plummeted, the good money acknowledged that it was far more probable that they would rise than continue falling and, without an interest rate yield, the opportunity costs were effectively eliminated. In other words, "there is no alternative" in which to invest than stocks (which was how TINA got her name).

Initially, the returns from stocks were fantastic with the market recovering in record time with the Dow returning to its pre-October 2008 levels in about a year and setting a new all-time high in March 2013. However, maintaining an artificially low interest rates has had its negative affects otherwise.

When I first started in finance, the known expectations for retirement planning was that stocks would get 9-11%, bonds would get 6-7%, and a cash position would get 2-3% (at times, falling below the pace of inflation).  Nowadays, the revised expectations place stocks getting 6-8%, bonds getting 4-5% and cash returning nothing.

Prime Money would return $250 on $11,000 over 8 years.

Therefore, anyone approaching retirement would need to review and likely revise their retirement plans because it would be too risky (in fact, foolhardy) to expect the old school returns in investments to be restored.  The difference in current returns in all investment classes is, across the board, effectively equal to the zeroed federal funds rate.

Whether the federal funds rate (or the recent regulation changes in Money Market Funds, which are required by October 2016) boosts the return of the Money Market Funds is almost irrelevant if the retirement plan is set to the worst case scenario, which is basically where the economy is right now. Because if you have planned for the worst, then anything else is an improvement -- and having more money in retirement than needed is hard to qualify as a problem.