These lessons may surprise you.

Part One Of A Two-Part Series

    Let's start with a quiz. Who first said: "It ain't so much the things we don't know that get us into trouble. It's the things we do know that just ain't so."
Was it:
    a. Samuel Langhorne Clemens (a.k.a. Mark Twain)
    b. Charles Farrar Browne (a.k.a. Artemus Ward)
    c. Henry Wheeler Shaw (a.k.a. Josh Billings)
    d. Frank McKinney "Kin" Hubbard
    e. William Penn Adair "Will" Rogers
    I first heard this quote in 1977. While it caught my attention at the time, it has taken on greater significance over the years. I tried to find it last year but couldn't remember, for sure, who said it (even though I seemed to recall that it might have been Will Rogers). Recently I consulted the fount of all knowledge-Google. My first search yielded three sources: Twain, Billings and Rogers were each attributed with great certitude. The irony was too funny. Three people obviously thought they knew the source of a quote on knowing, but at least two really didn't know. My inquisitiveness went into overdrive. I eventually found the following explanation from an impeachable source: the well-known and often-quoted Penngrove, Calif., Church of Christ Web site:
    Pundits often quote the famous saying by Will Rogers, "It ain't so much the things we don't know that get us in trouble. It's the things we know that ain't so."
    Only sometimes, the person using the quotation attributes it to Kin Hubbard, a humorist who was a contemporary of Rogers. Or to America's most noted humor writer, Samuel Langhorne Clemens, better known as Mark Twain. Or to 19th-century sage Henry Wheeler Shaw, who used the pen name Josh Billings.
    The irony for those who "know" Rogers or Hubbard or Twain or Billings first penned this classic comment is: what they know ain't so. The oldest citation of the saying does not appear in the works of any of the esteemed gentlemen already named, but in the writings of newspaper scribe and editor Charles Farrar Browne, who wrote satire columns under the pseudonym Artemus Ward. Browne died in 1867, seven years before the "ain't so" maxim appeared in Billings' writings, and before Hubbard (1868) and Rogers (1879) were born. (I think it's safe to say Browne didn't borrow it from any of them.)
    It appears that none of the initial three sources were correct. How could this happen? I'm sure they didn't intentionally mislead; they thought they were right. They might have even heard the quote in a keynote speech at a national conference! Financial planners are subject to the same tendency. Over the years there are any number of things that we have "known:"
    a. AAA Stanger-rated, Publicly Traded, Mortgage Limited Partnerships are safe investments
    b. High-yielding universal life is superior to a whole life insurance policy with a 5% interest rate guarantee
    c. Buying the "Dogs of the Dow" is a sure way to outperform the 30 Dow Jones Industrials
    d. "As goes General Motors, so goes America."
    e. Quarterly rebalancing is the superior methodology for portfolio management
    At one time or another I've believed each of these truisms only to learn that what I had "known" just ain't so. The last one, on quarterly rebalancing, is the focus of this article. For years I "knew" that quarterly rebalancing was the way to keep client portfolios properly aligned. That was great when we had 50 clients. As our clientele grew, that approach became unmanageable. To actually manage the process, we attempted to rebalance client portfolios on an annual basis, one-fourth of our clients in each quarter. Truth be told, we operated under the "squeaky wheel gets the grease" principle, whereby the clients who called the most often got the lion's share of our attention.
    The aftermath of 9/11/01 changed all of that. While it should have come as no surprise, as I reviewed 2001 annual performance data, I found that clients who were rebalanced in the fourth quarter clearly outperformed the rest of our clientele. Without intending to, we produced an outcome that felt "unfair" to me for three-fourths of our clients.
    Calendar rebalancing had several advantages: It sounded disciplined. It created the illusion of activity. And after all, since there were no technology systems in place to "ring a bell" when a portfolio was "out of balance," we appeared to be left with no other option. The journal articles I had read utilized assumptions that rendered them virtually useless for practical application.
    The problem with calendar rebalancing is that it can totally miss the time points where rebalancing can yield the greatest payoff. Markets simply don't know what month it is; they move randomly. Further, calendar rebalancing can create unnecessary transaction costs and tax liability if it's done blindly.
    In early 2002, one of our younger associates completed a simple study on the impact of conditional rebalancing using three asset classes. This motivated me to carry the study further, so that it would incorporate a "real-world" investment process that we could actually employ. Here were some of the issues and variables that we wanted our model to explore, by permitting:
    1. a variety of allocations covering a wide range of risk/return options
    2. a choice of time frames
    3. testing the impact of sector funds
    4. in the case of conditional rebalancing, testing a wide range of trigger points
    We wanted to know which rebalancing methodology was most likely to provide superior results for our clients. This meant that the model should be capable of testing the following methods of rebalancing:
    1. No Rebalancing
    2. Calendar Rebalancing
    a. Quarterly
    b. Annual
    c. Bi-Annual
    d. Tri-Annual
    3. Conditional Rebalancing, using variance triggers of 1% to 100%

    This is the third time I've run this analysis. The first time was at the end of 2001, the second time was at the end of 2003 and this time the data ends on March 31, 2005. While the model uses data beginning in 1968, the data period for some asset classes is much shorter which, when included in the calculations, caused the resulting portfolios to use that same, more limited time period. We constructed five portfolios that we labeled Capital Preservation, Income, Growth & Income, Growth and Aggressive Growth. A general theme emerged: Conditional rebalancing, using a 25% variance trigger, provided superior results. Simply put, if the target allocation for an asset class was 10%, and then over time the actual allocation for that asset class rose to 12.5% of the portfolio or sank below 7.5% of the portfolio (the 25% plus or minus variance), it was time to rebalance the portfolio.
    I shared these results in early 2002 with several friends, including Dusty Huxford, owner of dbCAMS, our portfolio management software. Dusty quickly gave us the technical capability to apply the initial findings to client portfolios. We could finally determine which clients had asset classes outside of a selected tolerance range and create an exception report listing only those clients. We finally knew who really needed to be rebalanced. We could now focus our time and effort where it was needed. 

Rick Adkins is CEO of The Arkansas Financial Group Inc. in Little Rock, Ark.