Broker Check

Summer’s Almost Over; Time For Portfolio Rebalancing Act


by Darren L. Zagarola, CFP®, CPA, PFS

As published on Princeton.Patch.com, August 22, 2013

The summer is almost over, and if there are several items still not done from the summer “bucket” list, here’s one more: Rebalance your investment portfolios. While it won’t provide an additional summer memory, it will most likely help you enjoy summers well into your retirement.

Given the market returns so far this year, it’s even more important to review your investment portfolio to see what rebalancing needs to be done in order to bring it back in line with your goal allocation. As of mid-August, the S&P 500 is up 18 percent year-to-date, and is currently at double its historic average. The Barclays U.S. Aggregate Bond index, meanwhile, isn’t faring so well, down 2.71 percent this year as rising interest rates have wreaked havoc with bond funds. The MSCI EAFE Index, an international equity index, has performed well year-to-date, rising 9.6 percent.

Because of the strong performance of stocks in the U.S., especially given the bond market’s poor performance, an investor’s allocation between equities and fixed income (bonds) most likely will have changed from their long-term asset allocation goal.

The simplest rebalancing involves selling portions of investment classes that have done well and buying into investment classes that are priced at a value in order to return to a chosen mix of investments. Rebalancing does not involve changing your total approach based on market predictions or timing the market. At EKS Associates, we believe in a buy-and-hold strategy based on asset allocation. Studies have shown that more than 90 percent of an investor’s return is based on asset allocation.

Basically, in rebalancing, investors are selling assets with increased values and buying assets with lower values. Although this is counter intuitive to most, investors should want to sell an asset that has increased in value even if it might continue to increase in value. Remember, the entire asset does not have to be sold; just enough to rebalance the portfolio. For example, if a long-term goal is 60 percent equity investments and 40 percent fixed income, current market conditions have changed the allocation to 65 percent equities and 35 percent fixed income. Rebalancing would force the investor to sell 5 percent of the equity holdings since it has increased in value to 65 percent, and to purchase fixed-income investments at their lower values. By selling the 5 percent equities, an investor locks in those gains, and they are no longer at risk in the market.

As quick background, asset allocation is the mix of investment vehicles in an investor’s portfolio. Typically it consists of balancing conservative versus more risky investments. As I’ve mentioned in previous columns, one’s personal needs, combined with their risk tolerance, helps determine the investment allocation, or the mix of equity investments and fixed-income investments maintained in their portfolio.

When first determining allocations and ensuring diversification, investors asked themselves how much should be allocated to equities (higher risk, higher expected returns) versus fixed income (lower risk and lower expected returns). And within those categories, what percentage of investment should be allocated among large-, mid- and small-cap investments, domestic versus international investments, and the many different types of fixed income investments?

Additionally, rebalancing a financial portfolio has several benefits:

It ensures the portfolio matches the investor’s well thought-out investment goals and plans, as stated in their personal investment policy statement. (If you don’t have one, you should. It outlines investment goals, including asset allocation, target returns, short-term liquidity needs and risk tolerance.)

It forces investors to sell high and buy low, as the positions being sold are those that have grown in value and now represent a higher-than-intended percentage of the portfolio.

Selling high and buying low allows the investor to make money.

It ensures diversification, which protects an investor’s assets from undue risk. A portfolio in which one investment class performs much better than others will find itself top-heavy in that asset class, and will lack diversification. This year, an unbalanced portfolio might be top-heavy in stocks; in 2007-2008, it would have been bonds.

Having said this, there are changes that can be made to the investment mix during the portfolio rebalancing act while still staying true to a given asset allocation and long-term holding strategy. Specifically, within the fixed income area (i.e. bonds, which are conservative investments by nature), an investor may choose to move from long term fixed-income investments to shorter-term fixed-income investments. This is more of a tactical asset allocation change, and not an attempt to time the market, especially in a rising interest rate environment like we are currently expecting.

Rebalancing an investment portfolio at least once yearly, and ideally twice a year, ensures that the long-term goal and asset allocation strategy are in place. Doing so before the craziness of September kicks in will eliminate the potential stress about rebalancing for the rest of the year, and give you something else to think about while lounging poolside.