This article is composed by Bogleheads® forum member digarei
THIRTEEN (13) persons met in mid-town Sacramento on the Second Saturday of September 2016 at 10:30 AM to discuss the Cascading Asset Allocation Method™ and Optimal Lazy Rebalancing. ¹
Also on the agenda was a reading and discussion of a paper on the psychology of investing and the use of heuristics. Two short videos were scheduled near the start of the meeting but sound configuration issues plagued our best efforts so the showing was postponed. We’ll attempt to play them at a future meeting.
During the past three months, we’ve explored many aspects of investment planning:
- Initiating an Asset Allocation
- DCA vs. Lump Sum investing
- Introduction to Estate Planning
- Creating an Investment Policy Statement
- Tracking Personal Investor Returns using IRR
- Developing a Long Term Financial Plan using Excel
This month was most ambitious:
- Portfolio Rebalancing, a variant of Asset Allocation and Investor Psychology
Following introductions, the chair read from a short paper (“Knowing Yourself, Finding the thing that works”) and led a discussion that focused on trying to answer a question that followed from the material.
Highlights of the paper, subtitled ‘Mnemonics & Heuristics as they relate to the psychology of investing’, follows:
- Mnemonics is a way to remember things by association.
- Example: The Alphabet Song – learn the letters of the alphabet while singing the note associated with each letter in a simple melody (“A, B, C…”).
- Mnemonics can be simple or sophisticated (What they can’t be is… forgettable!).
- Heuristics are mental shortcuts (or ‘rules of thumb’).
- A heuristic could be an intuition or hunch, they influence our decisions.
- Heuristics are innate in humans, part of who we’ve evolved to be.
- Example: When we’re frightened suddenly, we tend to jump back (startle) without giving any thought to the nature or motivation of the perceived danger. It’s not a reliable indicator of real danger, just a short cut that likely saved any number of our ancestors on the savannah when being hunted by lions.
- Heuristics can also be acquired or learned.
We’ve read much about our faulty brains, the heuristics that have helped us survive
can work against us: confirmation bias, anchoring, Dunning–Kruger effect, loss aversion.
Two notable books have elucidated the heuristic attributes that can get us into trouble:
- Thinking, Fast and Slow by Daniel Kahneman – Behavioral Economics
- Misbehaving by Richard Thaler (University of Chicago)
However, our goal is to acquire the tools and tricks (shortcuts, heuristics) that:
- Make managing our investments easier; and that
- Empower us to think or see more clearly;
“The psychology of investing may be more important than your portfolio’s expense ratio or the dollars you pay for an advisor.” – digarei
We want to identify positive heuristics that can help us make good
financial decisions but how do we define them? First pass:
- Computer software/apps (eg. spreadsheets)
- Planning aids (eg. Investment Policy Statement)
- Formulas (eg. ‘Age in Bonds’; ’60/40′; ‘Internal Rate of Return IRR’)
Some examples from a more catholic approach:
- aphorism / metaphor / principle / moral
- a story / narrative / memoir / a melody
- wordplay [alliteration, rhyming slang, limerick]
Nearly anything will work, anything that has the capacity to shape our investing behavior,
to change our temperament for the better. Now, one question remains to ask ourselves…What mnemonic or heuristic has helped (or will help) me accomplish what I want to accomplish?
‘Cascading Asset Allocation / Optimal Lazy Rebalancing’
Chapter member digarei presented the content for this topic using the screen projector and afterward distributed a printed color version to those present.¹ The material was made available to all members by way of an email containing links to documents stored on Google Drive. The summation that follows below is necessarily cursory. Members can download the entire presentation using the URL link provided in the email, as well as supplementary information. ² ³
The presentation relied upon multiple tools/sources, indicated below, to create an efficient method of rebalancing.
1. Best Practices for Rebalancing • Vanguard (Nov. 2015)
- Periodic Rebalancing was helpful in controlling portfolio risk
- 1. 5% bands are fine. Don’t balance more than once or twice a year.
2. Cascading Asset Allocation Method™ (CAAM)4
- A visual top-down approach. The Finance Buff (TFB), 2007
- Divide each asset class to mirror portfolio.
3. Two-page spreadsheet inspired by CAAM
- . Left-Right approach w/color-coded asset classes.5
- BHs forum member, pradador (2012)
- Create a portfolio or rebalance using your target percentages.
- Also works in reverse, starting with sub-asset classes, right to left
4. Optimal Lazy Rebalancing • Albert Mao, 20136
- On-line calculator. Allows one to rebalance with contributions OR withdrawals.
- Objective is to “split up a new contribution so that you get as close as possible to your target allocation without making any ‘backwards’ transactions.”
- Additions (/withdrawals) move your portfolio closer toward your target AA.
- Accumulators (/Retirees) don’t have to sell (/buy), avoiding capital gains tax.
5. Excel spreadsheet • Greg (digarei) • (2015)
- Image captures are from my own investment spreadsheet.
- AA constructed, current fund valuations and formulas are automated.
- To establish AA, break out assets one column at a time, Right to Left.
- Determine % of total portfolio from columns 1 through 4.
To rebalance, I just cut & paste a block of cell data into the Optimal Lazy Rebalancing calculator, press a button and copy the results back into my spreadsheet. (< one minute) once or twice a year.
Using my spreadsheet to convey work flow
Starting with 100% (all investible liquid assets = portfolio), divide asset classes proportionally so that each part is associated with a percentage of your entire portfolio. An 80/20 stock/bond target has already been established in the examples below. My goal was to create (8) eight asset classes, to maintain separate buckets for Emerging Markets and REITS, and tilt domestic to Small Cap.
Slide 1: Cascade the allocations from right to left, from the biggest
to smallest asset classes. Goal: Split 80% stock to US + INT’L:
- 33% of STOCK will be INTERNATION’L: .33 x 80% = 26% of PORTFOLIO
- 67% of STOCK will be US DOMESTIC : .67 x 80% = 54% of PORTFOLIO
Next, Split out 20% Bonds to US + INT’L
- 20% of BONDS will be INTERNATION’L: .20 x 20% = 4% of PORTFOLIO
- 80% of BONDS will be US DOMESTIC : .80 x 20% = 16% of PORTFOLIO
Slide 2: Goal: Split out US Stock into Large, Mid, Small -Cap
Estimated Market Share:
- 66% of US STOCK will be LARGE CAP: .66 x 54% = 37% of PORTFOLIO
- 27% of US STOCK will be MID CAP: .27 x 54% = 15% of PORTFOLIO
- 7% of US STOCK will be SMALL CAP: .7 x 54% = 4% of PORTFOLIO
Example Shows Small Cap Tilt:
- 62% of US STOCK will be LARGE CAP: .62 x 54% = 33% of PORTFOLIO
- 28% of US STOCK will be MID CAP: .28 x 54% = 15% of PORTFOLIO
- 10% of US STOCK will be SMALL CAP: .10 x 54% = 5% of PORTFOLIO
Final steps – The goal was to create 8 asset classes and this was accomplished
in the spreadsheet, I tweaked the percentages to ensure they added up to 100%.
I created a separate worksheet to maintain my fund balances and wrote simple
formulas to populate a ‘Rebalancing’ section, where all funds are summed by
asset class. Some mutual funds and ETFs contain multiple classes. For example:
The portfolio includes $25,000 in Vanguard Total Stock Market (VTI, VTSAX, VTSMX)
but I have decided to break out US stocks into Large, Mid-Cap and Small-Cap US.
To correctly fill the asset classes in the ‘Rebalancing’ section, I need to extract %Small Cap
from Total Market and add it to Small Cap assets in Rebalancing, and so on…for any fund
containing multiple classes. I did this one time in a spreadsheet using simple formulas
so I wouldn’t have to do this every time I rebalance.
- Lrg Cap 25,000 X 66% = 16500
- Mid Cap 25,000 X 27% = 6750
- Sm Cap 25,000 X 07% = 1750
The sum of asset classes in Rebalancing should equal your total portfolio value. Then, it’s just a matter of cut & paste—from the Rebalancing section into the Optimal Lazy Rebalancing Calculator. If you need help with anything described in this section or would like some assistance in creating a spreadsheet, please ask during one of our monthly meetings or contact the chapter cooordinator. We have Excel gurus in our group
who can help you get started!
After the meeting, FIVE (5) members met for brunch at Veg Café at 24th and J Streets.
No audio recording was produced for this meeting.
¹ These tools were incorporated into a single presentation to demonstrate their viability together and create a linear work flow. The original premise had been entitled ‘Rebalance your Portfolio in 10 minutes’. Using the described asset allocation method in a standard spreadsheet that contains current balances for all of one’s investment accounts and utilizing the lazy rebalancing tool, an investor could plausibly rebalance their portfolio while making a contribution (or taking a withdrawal) in ten minutes or less.
² See contents of e-mail sent to members on Sept 11:
Subject: . SEPT 2016 MEETING DOCS
Date: . . . September 11, 2016 at 10:35:43 PM PDT
³ My apologies for the large size of some of the files stored on Google Drive. This month’s rebalancing presentation (“CAAM_OptLazRebal.pdf”) was surprisingly large (17 MB). Most files made available to the chapter are initially created in Microsoft Office Word, then exported to PDF format. Since this meeting I’ve acquired software that I will be using to substantially reduce the size of distributed files.
4Cascading Asset Allocation Method™
Harry Sit (The Finance Buff) September 27, 2007
5 Although its asset classes are clearly aligned horizontally, the tabs are
labeled “Top-Down” and “Bottom-Up”. Go figure: Forum discussion