Home > Understanding Investors > Rebalancing behavioral portfolios

Rebalancing behavioral portfolios

Think of an investor who had a $2 million portfolio in October 2007, $1 million in bonds and $1 million in stocks. Visit him again in February 2009 when his bonds are still worth $1 million but his stocks are worth only $500,000. What should he do now? Should he re-balance his portfolio? And, if so, how should he re-balance?

The initial portfolio was a 50/50 stock/bond portfolio and the standard advice is to re-balance back to a 50/50 portfolio by selling $250,000 worth of bonds and using the proceeds to buy $250,000 of stocks. This advice flows from two distinct reasons, one related to risk tolerance and the other to expected returns.

The risk tolerance reason is that an investor who has chosen a 50/50 portfolio has declared that his risk tolerance corresponds to an optimal 50/50 portfolio. The February 2009 portfolio is a 33.3/66.7 stock/bond portfolio, so it is sub-optimal. The portfolio can be made optimal again by restoring it to its 50/50 proportions.

The expected returns reason is that securities returns tend to be mean-reverting, so it is likely that the returns of stocks would be high relative to their long-term mean following periods where their returns were low relative to their mean, and the same is true for bonds. If our world of returns is a mean-reverting world then investors benefits by buying stocks just before their returns are especially high and selling them just before their returns are especially low. In a recent exchange of letters to the editor of the Financial Analysts Journal, William Bernstein argued that our world is a mean-reverting world while William Sharpe argued that it is not clear that this is our world.

The re-balancing answer of behavioral portfolio theory is quite different from these two answers. The investor with a $2 million portfolio chose to invest $1 million in stocks and $1 million in bonds because he has two distinct goals reflected in two mental accounts or “buckets.” Being-rich is one goal, and that is the purpose of the $1 million in stocks. Not-being-poor is the other goal, and that is the purpose of the $1 million in bonds. We can think of the not-being-poor goal as the goal of retirement at a basic level of comfort. We can think of the being-rich goal as the goal of enjoying luxuries in retirement or leaving a substantial bequest to children or charity.

A “behavioral investor” might well object to selling bonds from his not-being-poor mental account because the proceeds of such sales might be lost if invested in stocks, diminishing his basic level of comfort in retirement. Our investor has good reason to refuse the usual re-balancing advice and financial advisers should listen to him.

Advertisements
  1. No comments yet.
  1. No trackbacks yet.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: