Rebalancing when its UGLY out there

If you're like most investors, your portfolio has seen some pretty dramatic swings in the last 3 months. The S&P 500 has declined 19.4% since its high mark in mid October 2007 to its recent low on January 23, 2008.

And because some assets go up or stay steady while others fall, your asset allocation is probably out of whack by more than just a percent or two. It’s probably time to rebalance. Argh. Nobody wants to sell their winners and feed the dogs, c’mon. There has got to be a better way.

The best way I know to keep an allocation balanced, is to adjust my dollar cost averaging scheme. I prefer to affect the rebalance by adding new money to the asset that is lagging. I am able to stomach that more easily since the purchases are in small chunks and I am letting my winners run. I also adhere to the classic rationalization that I am buying more shares at cheaper prices.

When my asset allocations start to deviate from my plan by more than a couple of percent, I take action. I begin by redirecting a DCA purchase from a winner to the lagging asset, which could result in doubling up on the amount of money going into a particular asset.

VGSLX is at the top of my laggard list. It’s a Real Estate Investment Trust fund and it’s the worst performing asset that I own. However, it is a permanent holding, meaning it is part of my diversified portfolio that I plan to hang on to forever. Forever is a long time and certainly this fund will rebound given some time.

Of course, we would all like to buy in at the bottom. I keep watching VGSLX gyrate up and down, but mostly down. How bad are things going to get? Is the economy going to slow down even more? With all these uncertainties – it’s a good thing that I have DCA or I might never buy in!

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Admiral shares Conversion

I have another fund at Vanguard that has recently qualified for conversion from Investor shares to Admiral. The Admiral shares are a lower-cost version of the same fund that is limited to investors with $100,000 or more in an account that has been held at VG for a minimum of 3 years. It’s a wonderful thing and once again the spoils are given to the clients with the most money. It goes to reason that clients with 100k or more are less likely to jump in and out of a fund, so its easier for VG to manage. Its easier meaning its less costly because the fund does not have to sell shares to meet the demands of traders. Managing an index fund is most efficient with a steady money pool.

Key points of the conversion
1. The conversion is free, there are no tax implications
2. The ticker symbol changes
3. Expenses drop by 33%!!!! VG is well known for its low cost, low fee index funds. The average expense for a fund in the same category is over 10 times that of VG!

What about ETFs, aren’t their expenses even lower?
Yes, they can be. I found a comparable ETF with an expense ratio of 0.12, that’s 0.02 cheaper than the VG Admiral fund. They also do not have the 100k minimum requirement. The downside is that ETFs require a commission to buy and sell and the commission makes dollar cost averaging very inefficient. If you don’t have the 100k, buying an ETF through Zecco (free trades) is an attractive option. However, with such a large sum I am definitely more comfortable investing through a proven and trusted institution such as VG.

Dollar Cost Averaging (DCA) gets beat by Value Averaging (VA)!

The results are in and DCA loses in the stretch. Ah darn, I love DCA. Its mindless, emotionless, and easy. Besides who ever heard of VA?

The VA approach sets a target growth rate and then adjusts new deposits based on the performance of the fund. Huh? Let's say you want a 12% return that equates to 1% growth per month. Okay, now you invest $1000 and it grows in one month to 1015 or 1.5%. This exceeds your target, so next month you adjust your monthly contribution down 0.5% to 995. Conversely, if the fund performance lags the 1% target, you increase your investment by the corresponding dollar amount.

So is it worth changing to VA?
5000 Monte Carlo simulations later and the answer is – “It is optimal to follow the 401(k) value-averaging strategy with a target annual growth rate between 8 percent and 12 percent.”

The table shows that 67% or a majority of the time (for 5000 simulations) the VA approach beats DCA. Given 30 years or 360 months using a target rate of 1% per month and monthly contributions of 1000, the mean final value of the DCA portfolio is 7.8% less than the VA portfolio. Who would have thought such a small change could make that much difference? I was skeptical about such a large differential. I created a spread sheet, ran a few test cases and although VA did have better returns than DCA, I did not see the differences of the magnitude shown in the table.

Whats so cool about VA?
It makes me feel like I am in control! I am the decider and after I finish my calculations every month I will direct a specific amount of money into my retirement account. I am no longer just standing by while the market whips my funds around. I am actively managing my finances!

Blinded by science
The data is staring right at you. A logical Personal Financier would change from DCA to VA, right? Ugh. Okay, I pledge that I will change at least one DCA account to VA this month.