The 3 Steps to Rebalancing Your Portfolio
When interest rates stagnate at historic lows, many investing experts say it has become harder to keep investment allocations in proper balance.
With interest rates projected to stay low or volatile for the immediate future, what used to be a formula driven exercise has become even more challenging. For this reason, some of the traditional "equity versus fixed income" formulas need to be very carefully watched especially if interest rates go higher.
Rebalancing your investment portfolio is still a simple strategy and it still makes sense to do this at regular intervals so your investments are closely aligned with your long-term financial plan. That generally means periodically reviewing your portfolio’s mix of investments.
After a market rise, many investors lighten the upside (and downside) potential of equities with hopefully less volatile returns of fixed income when one or the other gets overinflated in your portfolio.
While rebalancing does not assure superior performance, it does keep portfolios updated on targeted asset allocations.
What Is Rebalancing?
According to Investopedia.com, rebalancing is defined as the process of buying and selling portions of your portfolio in order to set the weight of each asset class back to its original state.
In addition, if an investor's investment strategy or tolerance for risk has changed, he or she can use rebalancing to readjust the weightings of each security or asset class in the portfolio to fulfill a newly devised asset allocation.
Traditional rebalancing can be broken down into three steps: two traditional and one newer approach.
The First Step to Traditional Rebalancing
When you design your investment plan, you decide your ideal mix of equity and income based on your personal situation, including your long-term goals and risk tolerance.
The Second Step to Traditional Rebalancing
As your investment portfolio’s value changes, you need to check it periodically to see how your personal mix of investments move with market changes.
You should then consider adjusting your holdings to reflect your personal situation by reviewing your: goals, age and risk appropriateness. For many investors, tax time is one of the more popular times to perform this checkup.
When you finish rebalancing, your hope is to sell what has increased and could potentially be high and buy what has not reached a greater value and is possibly low. Traditional rebalancing is supposed to give investors the discipline to attempt to do that.
Traditional Steps Take a Turn with Lower Interest Rates
Currently, with many fixed income vehicles at artificially low rates, the old formula of shifting between stocks and bonds needs to be revisited during this process.
"I would move away from the price risk of bonds, and I would be worried about adding to them right now," says Charles Ellis, former chairman of the Yale Endowment. "I would be looking for another form of income. When it comes to fixed income, you have to consider if I really need that, and if I can I get income in any other way."
In keeping a balanced portfolio, debt securities have nearly always provided a natural hedge: traditionally bonds have usually gained in value when stocks went down. Their yields have risen proportionately when stocks have gone up (mostly during an improving economy).
For decades, rebalancing provided a virtuous circle that way, and as a result, it kept people from letting emotions rule investments, says Ellis. That rule still holds, even if the asset mix is changing.
The rule of thumb has traditionally been "100 minus your age." It tells you roughly how much equity you should have. Doing that math, at age 40, your equity should be 60 percent and the rest should be fixed income. At 60, those numbers are flipped, with 60 percent in fixed income and 40 percent in stocks.
Thanks to low interest rates, this strategy may no longer be appropriate.
The Third Step to Traditional Rebalancing
When you design your investment plan, you decide your ideal amounts for fixed income. With interest rates artificially low, these types of investments can generate an unusual amount of “interest rate risk.”
According to Investopedia.com, “Interest rate risk affects the value of bonds more directly than stocks, and it is a major risk to all bondholders. As interest rates rise, bond prices fall and vice versa.
The rationale is that as interest rates increase, the opportunity cost of holding a bond decreases since investors are able to realize greater yields by switching to other investments that reflect the higher interest rate.
For example, a 5% bond is worth more if interest rates decrease since the bondholder receives a fixed rate of return relative to the market, which is offering a lower rate of return as a result of the decrease in rates.
Due to increased interest rate risks, some investment professionals have looked elsewhere when appropriate. (i.e. the income-producing side of equities, or preferred shares).
"Laddering" with a series of short-term bonds can be another way to address this problem, since low-duration debt reaches maturity in a short time. While one- to five-year securities pay little in yield, at least investors recover some or all of their invested capital when the security matures, unless they overpaid for the bonds in the secondary market.
As a result, dividend-paying stocks are taking up a larger share of the dollars earmarked for "income" in some allocations models. While that can make some sense at a time when the average stock dividend on the Standard & Poor's 500 index is higher than the 10-year Treasury bond, it's not an even trade because stocks are still almost always a riskier proposition than bonds.
The Consequences of Imbalance
A popular belief among many investors is that if an investment has performed well over the last year, it should perform well over the next year.
Unfortunately, past performance is not always an indication of future performance. This is a fact many investments disclose, but still many investors remain heavily invested in last year's "winning" portfolios and may drop their portfolio weighing in last year's "losing" portfolios.
Remember, equities are more volatile than fixed-income securities, so the source of last year's large gains may translate into losses over the next year.
Normal rebalancing rules would suggest that with a large gain in stocks since the start of last year, investors should start lightening up on equities. Meanwhile, they should be switching to fixed income investments to restore that balance.
However, bond prices are currently high, and yields are low. A number of investing allocation experts are currently leery of loading up on more fixed income, especially with the Federal Reserve still keeping interest rates low, and rates are expected to rise.
The Importance of Rebalancing Your Portfolio
The primary goal of rebalancing is to focus on minimizing an investor’s risk by staying within targeted allocations; it is not a pursuit of maximizing your investment returns.
Rebalancing your portfolio can help you maintain your original asset-allocation strategy and allow you to implement any changes you make to your investing style.
The optimal frequency of portfolio rebalancing depends on your transaction costs, personal preferences, and tax considerations, including what type of account you are selling from and whether your capital gains or losses will be taxed at a short-term versus long-term rate. This is where a qualified advisor can provide help.
How often and how much of your portfolio you need to rebalance is where a qualified financial advisor can add value. Simple rebalancing suggests that your entire portfolio is performing well, and sometimes that might not be the case. Essentially, rebalancing tries to help you stick to your investing plan regardless of what the market does.
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This article is for informational purposes only. This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice as individual situations will vary. For specific advice about your situation, please consult with a lawyer or financial professional. Investing involves risk including the potential loss of principal. No investment strategy, such as rebalancing and asset allocation, can guarantee a profit or protect against loss in periods of declining values. Rebalancing investments may cause investors to incur transaction costs and, when rebalancing a non-retirement account, taxable events will be created that may increase your tax liability. Indexes are unmanaged and investors are not able to invest directly into any index. Past performance is no guarantee of future results. In general, the bond market is volatile as prices rise when interest rates fall and vice versa. This effect is usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss. The payment of dividends is not guaranteed. Companies may reduce or eliminate the payment of dividends at any given time.