Rebalancing an investment portfolio is supposed to be a relatively simple way to keep your strategy aligned with your goals and risk tolerance.
With U.S. stocks having had a volatile past two months, joining longer-term declines for international stocks, it might seem to be a good time to re-evaluate your investment mix and rebalance to your targeted weight for stocks, bonds and cash.
Of course, to rebalance, you need to have previously determined your optimal mix of stocks, bonds and cash for your investment portfolio.
For investors without documented preferences for how to invest, there’s never a better time to start than now. For investors who do follow a methodology for how they allocate their money, rebalancing should be standard operating procedure.
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Unfortunately, any time there is a psychological element involved — such as human nature — it can be difficult to remain committed to standard procedures.
Particularly when stock prices are decreasing, it can be difficult to have confidence to move money into stocks. Sure, you might be buying a temporary dip. But that dip might widen before temporary becomes the more important description.
This year has led to a rebalancing conundrum. How should you rebalance in an environment where nearly everything is declining?
Deutsche Bank tracks 70 slices of global financial markets. As reported in The Wall Street Journal, 90 percent of the assets that Deutsche tracks had declined year-to-date through Nov. 25. That is the highest percentage of declining asset types in Deutsche’s analysis since 1901.
The need to rebalance should be dictated by relative performance. If one type of investment has declined, a diversified portfolio generally would hold other assets expected to have inverse behavior.
This is the expected conduct between stocks and bonds. Bonds generally are viewed as a safety asset class that will protect value when stocks are in “corrections” and bear markets. But the past year-plus for bonds has been challenging as interest rates climbed, causing prices for current bonds to decline.
With many segments of global stock and bond markets posting uninspiring performance, your current investment mix might not have deviated much from your target despite the attention that stock declines have drawn over the past couple months.
We’re approaching year-end but there is no need to rebalance on a specific schedule just because a calendar turned. This might cause you to be overactive, increasing transaction costs. It’s better to rebalance from a rules-based approach that considers the amount of drift from your targeted weight of each asset class — commonly 5 percent or more — to be the trigger for action.
Choosing the perfect time to rebalance is often difficult. Don’t expect to precisely align your money movement with inflection points in market prices. You might need to rebalance multiple times during a prolonged stock market upturn or downturn.
A simplified way to not have to make rebalance decisions, or decide which direction to invest new contributions, is to use balanced mutual funds or exchange-traded funds that hold a pre-determined mix of stocks and bonds.
They will auto-rebalance to the intended allocation using cash flow into and out of the fund from all shareholders. Target retirement date funds are good for this purpose.
Other balanced funds — following a variety of strategies from conservative to aggressive — can help shareholders stay close to their comfort zone without needing to monitor and make decisions.
For those that take a more involved approach, there is a second layer of considerations for how to rebalance a portfolio. You can move beyond the high-level stocks vs. bonds weight to think more about the underlying makeup of these markets, rebalancing within asset classes.
Among stocks over the past year, U.S. companies have widely outperformed international. It might be wise to boost the international weight in your investment mix.
To a larger extent, growth stocks have dominated value stocks over the past several years. If we can trust history, this is cyclical activity. It might be worth tilting back toward value stocks.
Within bonds, it might be wise to reduce the weight of high-yield “junk” and floating rate bank loans. These categories carry higher risk and possibly not enough compensation to justify the extra risk. Instead, rebalance to shorter-term, higher-quality bonds — an area of the market that might be a good fit as interest rates continue to rise.
As you rebalance, also think more about where you hold certain types of investments.
Keep income-paying investments (bonds, real estate investment trusts, dividend paying stocks) in tax-deferred retirement accounts. Hold your highest potential return positions in Roth accounts to take advantage of tax-free growth. Reserve non-retirement brokerage accounts for stocks, particularly those that don’t pay dividends, or index funds.
These asset location decisions can increase your after-tax returns.
Gary Brooks is a certified financial planner and the president of BHJ Wealth Advisors, a registered investment adviser in Gig Harbor.