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Do Target Retirement Funds Automatically “Buy Low, Sell High”?

A reader writes in, asking:

“Like you, I like the idea of ‘all in one funds,’ specifically the Vanguard Lifestrategy series. I have a significant portion of my IRA in Lifestrategy Moderate Growth. What I’ve wondered about is how those funds handle rebalancing during the type of market volatility we’re experiencing now-i.e., is it done on a continual basis, as new cash comes in and distributions go out? Or quarterly? Is it inherent in these fixed-ratio funds that they will, to some extent at least, ‘buy low and sell high?'”

Vanguard’s LifeStrategy and Target Retirement funds use daily cash flows into (or out of) the fund to rebalance the portfolio. Beyond that, further rebalancing only occurs if the fund’s allocation strays outside of a certain target range (which Vanguard does not publish). You can find a bit more info in this interview with Vanguard’s John Ameriks.

And, I would not say that it is inherent that the funds-of-funds will automate a “buy low, sell high” process. In periods during which the market exhibits momentum (as opposed to mean reversion), the funds’ daily rebalancing will actually harm performance rather than help it.

For example, if the stock market continues to drop slowly but steadily for an extended period, an investor in a LifeStrategy fund would experience greater losses than an investor who had a DIY allocation that was originally identical but never rebalanced over the period. (Reason being that the LifeStrategy investor will keep rebalancing into stocks every day, only to see them decline further.)

And the same thing happens if the market goes up steadily for an extended period. That is, the LifeStrategy investor will constantly be selling stocks, only to see them move up further, and he/she will therefore underperform the DIY investor who doesn’t rebalance over the period.

But the opposite can happen as well.

If a decline turns out to be a steep but short-lived dip, the investor in the LifeStrategy fund will have gotten to buy some shares “on sale” whereas the DIY investor who didn’t rebalance will not have purchased any such “cheap” shares.

And if a brief rally occurs during a bear market, the investor in the LifeStrategy fund will have sold some stocks at the temporarily-relatively-high price, whereas the DIY investor who didn’t rebalance will not have done so.

In short, during periods in which the market heads relatively steadily in one direction, frequent rebalancing (as you would experience in a LifeStrategy or Target Retirement fund) will generally underperform a strategy that involves less frequent rebalancing. Conversely, during periods in which the market rapidly bounces back and forth, frequent rebalancing will usually outperform a less frequent rebalancing strategy.

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