Wednesday, Jan. 13
Posted 2 p.m. EST
Are you nervous about investing in the decade ahead? The 2000s, or "Aughts," have been dubbed the "lost decade" due to the wipeout of investment returns by two treacherous bear markets. The S&P 500 index logged an annualized loss of 0.949 percent (including dividends) over 10 years, according to Standard & Poor's. That means a $10,000 investment in an S&P fund was worth $9,091 when it was all over, not including costs that would have been incurred with the index fund. If you take inflation into account, its value dropped substantially more.
But market pundits keep saying that if you rebalanced your portfolio each year, it wasn't a lost decade after all. Of course, rebalancing assumes ownership of more than one fund. So what would have happened to the value of your portfolio if you invested 60 percent of it in the S&P 500 and 40 percent in a bond fund that approximates the Barclays Capital Aggregate Bond Index, formerly known as the Lehman Aggregate? How much would it have been worth if you rebalanced at the end of each year, or if you just let it ride?
I asked Morningstar to run some numbers, and here's the tally: The annualized return was 2.6 percent for those who rebalanced, and 2.53 percent for those who did not. At least these portfolios gained something. Bonds beefed up returns, and rebalancing helped a smidgen. In dollar terms (not accounting for inflation), the neglected 60/40 portfolio would be worth $12,838 vs. $12,926 for the rebalanced portfolio. That amounts to a difference of about $80 for the trouble of rebalancing each year for 10 years. Not a lot of compensation for the trouble.
A look at boomer portfolio returnsStill, the smart investor diversifies among more than two asset classes. What happened if you had the following portfolio: 30 percent in large-cap domestic stocks, 15 percent in mid-caps, 6 percent in small-caps, 7 percent in European stocks, 3 percent in Asia, 2 percent in emerging markets and 37 percent in fixed income? This is the recommended asset allocation for baby boomers between 50 and 60 years of age, courtesy of the Vanguard Group. Let's call these "boomer portfolios."
Over the past 10 years, the rebalanced boomer portfolio fared better, with a return of 4.51 percent vs. 4.2 percent for the neglected boomer portfolio. Notice these returns are substantially higher than the simplified 60/40 portfolios described above. A $10,000 investment would have grown to $15,090 in the neglected boomer portfolio, or $15,545 in the rebalanced one. The differential for rebalancing is $455. But the differential between the boomer portfolios versus the 60/40 portfolios is much bigger -- more than $2,600 between the rebalanced versions of each.
The roaring 90sWhat if we looked at returns over the past 20 years? The 1990s was a decade of excess, remember? Returns on an annualized basis ranged from 13.26 percent to 14.97 percent among these portfolios. I'm feeling so nostalgic just remembering that wonderful era of 20-percent-plus returns of the S&P 500 during most of the 90s!
Interestingly, the simplified 60/40 portfolios outshone the boomer ones in that 10-year period, and the ones that were not rebalanced did better than those that were in both portfolio types.
How diversification, rebalancing impact returns
Copyright 2010 Morningstar, Inc. Returns are annualized. Note that this data is based on index returns, which do not take fund expenses into account.
But over the entire 20-year period, the boomer portfolio that had been rebalanced each year came in first place, with an annualized return of 8.8 percent. This compares to the 8.49 percent return of the neglected boomer portfolio, which came in second place.
It's a difference of 31 basis points, or 0.31 percent. That may not seem like a big deal, but it makes a big difference over, say, 30 years. For illustration purposes, a $10,000 investment earning 8.8 percent a year would be worth $125,565 after 30 years. But the same investment earning 8.49 percent would be worth $115,263 after three decades. That 10 grand difference could buy a lot of groceries in retirement.
Bottom line: It pays to have exposure to several asset classes because you never know which ones will kick butt. And rebalancing once a year can make a significant difference over the long term -- especially if you don't anticipate skyscraper returns going forward.
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