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.