This post is the first of several examining the basis of my June 3 post, What Now: Sell, Rebalance, or Rotate? Today, the topic is whether rebalancing a portfolio of stocks and bonds was an effective strategy in the past 25 years for investors in Japanese markets. In the days ahead, I'll present similar data for Germany and the U.S., and for a strategy of rotation rather than rebalancing.
The chart above summarizes total returns for three portfolios invested in Japanese markets from April 1994 through March 2019. All the underlying data for prices, interest, total returns, and inflation are in local currency (Yen).
During this period, a prescient investor would have simply bought 10-year government bonds and held them. No stocks, no rebalancing, no worry! Why so?
At one point, government bonds were 10.5% below their previous peak for the period, as indicated by the bar for 25-year drawdown in the chart. Looking at your portfolio and seeing an unrealized loss over 10% could be troublesome. But you would have seen much worse with an all-stocks portfolio (-66.4%). A portfolio invested 50-50 in Japanese 10-year government bonds and the Nikkei 225, rebalanced monthly if it drifted to 45-55, would have mitigated the drawdown, yet remained alarming (-31.3%). In short, bonds had the least-bad losses.
Those drawdowns were not instantaneous. They evolved over several months. Could you have seen them coming, and perhaps taken some action? One way of doing so would be to monitor your portfolio every month, and assess the drawdown since the previous month. Had you done so, your worst monthly outcomes would have been -4.6% for bonds, -23.8% for stocks, and -10.7% for rebalancing. Losses of this magnitude can occur in a single day, as they did in the U.S. in 1929 and 1987. So the maximum drawdown in any month is credible as an estimate of the risk that is unavoidable for a portfolio. If you consider a potential unavoidable loss of 10% to be tolerable, then, at least for the case of recent history in Japan, rebalancing might be, for you, a strategy worth considering.
Potential drawdowns would be the only criterion that mattered if you were concerned exclusively about risks, not about benefits. Realistically, you likely have a personal preference to accept some temporary risk, provided that you get some eventual reward. Maybe you will tolerate a transient drawdown of X% if, in the long run, you stand to gain Y%.
With long-run returns, one concern (in fact, a hidden but pernicious risk) is that they may cover a period with high inflation. If your long-run return is 10% but inflation is 8%, your buying power, or real return, is just 2%. Thus, the risk-benefit calculation requires, in this data, comparing drawdowns with real (inflation-adjusted) returns.
Happily, in Japan for the last 25 years, inflation was nearly zero. In some years, the opposite occurred, with deflationary declines in prices that occasionally made bonds the indisputable investment of choice. As shown in the chart, rebalancing captured some of these benefits, matching an all-bonds portfolio over the full 25-year period; both portfolios generated real returns near +2%. Stocks, if you held them all that time, would have eventually pulled your results into the black, but only barely (+0.3% after adjusting for inflation).
In hindsight, had you been there, years ago, deciding how to invest in Japan for the next quarter-century, would you have gone all-in on government bonds? If not, and you instead opted for the compromise method of rebalancing, you would have done equally well in the end, and measurably better than by putting all your money on stocks. Along the way, however, you would have had to weather some nasty storms. In subsequent posts, I'll examine whether Germany and the U.S. were similar and whether, in all three countries, rotation would have proven superior.
During this period, a prescient investor would have simply bought 10-year government bonds and held them. No stocks, no rebalancing, no worry! Why so?
At one point, government bonds were 10.5% below their previous peak for the period, as indicated by the bar for 25-year drawdown in the chart. Looking at your portfolio and seeing an unrealized loss over 10% could be troublesome. But you would have seen much worse with an all-stocks portfolio (-66.4%). A portfolio invested 50-50 in Japanese 10-year government bonds and the Nikkei 225, rebalanced monthly if it drifted to 45-55, would have mitigated the drawdown, yet remained alarming (-31.3%). In short, bonds had the least-bad losses.
Those drawdowns were not instantaneous. They evolved over several months. Could you have seen them coming, and perhaps taken some action? One way of doing so would be to monitor your portfolio every month, and assess the drawdown since the previous month. Had you done so, your worst monthly outcomes would have been -4.6% for bonds, -23.8% for stocks, and -10.7% for rebalancing. Losses of this magnitude can occur in a single day, as they did in the U.S. in 1929 and 1987. So the maximum drawdown in any month is credible as an estimate of the risk that is unavoidable for a portfolio. If you consider a potential unavoidable loss of 10% to be tolerable, then, at least for the case of recent history in Japan, rebalancing might be, for you, a strategy worth considering.
Potential drawdowns would be the only criterion that mattered if you were concerned exclusively about risks, not about benefits. Realistically, you likely have a personal preference to accept some temporary risk, provided that you get some eventual reward. Maybe you will tolerate a transient drawdown of X% if, in the long run, you stand to gain Y%.
With long-run returns, one concern (in fact, a hidden but pernicious risk) is that they may cover a period with high inflation. If your long-run return is 10% but inflation is 8%, your buying power, or real return, is just 2%. Thus, the risk-benefit calculation requires, in this data, comparing drawdowns with real (inflation-adjusted) returns.
Happily, in Japan for the last 25 years, inflation was nearly zero. In some years, the opposite occurred, with deflationary declines in prices that occasionally made bonds the indisputable investment of choice. As shown in the chart, rebalancing captured some of these benefits, matching an all-bonds portfolio over the full 25-year period; both portfolios generated real returns near +2%. Stocks, if you held them all that time, would have eventually pulled your results into the black, but only barely (+0.3% after adjusting for inflation).
In hindsight, had you been there, years ago, deciding how to invest in Japan for the next quarter-century, would you have gone all-in on government bonds? If not, and you instead opted for the compromise method of rebalancing, you would have done equally well in the end, and measurably better than by putting all your money on stocks. Along the way, however, you would have had to weather some nasty storms. In subsequent posts, I'll examine whether Germany and the U.S. were similar and whether, in all three countries, rotation would have proven superior.
RSS Feed