THE FISCAL BLUE PRINT

WITH COACH JEFF MONTGOMERY

Episode 25: The Rebalancing Act… continued!

Here are just a handful of the things that you’ll learn:

The reason we rebalance is to control the amount of RISK inside our portfolio!  So on today’s show we are going to give you some hypothetical examples of well-designed diversified portfolios and show you what happens over time when you don’t’ rebalance and then we will show you the simple process of how to rebalance a globally diversified portfolio

 

(1:50) Practical Planning: Ok so in our practical planning segment we are going to look at a hypothetical portfolio of 50% equites and 50% fixed income.

 

Now this may be difficult from a visual perspective to demonstrate this over a podcast format.  So, if you’re not driving you might want to take out a blank piece of paper and a pencil and draw a big circle on it and then draw a line right down the middle of the circle dividing the circle in halves.

 

Let’s look at a hypothetical portfolio of 50% equities and 50% fixed income. Now in reality when you have a professionally engineered mix you will have a lot more slices to the pie representing exact percentages of various asset classes.  Why? In order to take advantage of the benefits of rebalancing it is critical to have a well-diversified portfolio built from several asset classes with dissimilar price movements. This asset classes won’t move in perfect correlation to each other and that’s generally a good thing!

 

So normally, in our equity portion we will have US small stocks, US small value, US large, US large value, International large, and international small. In our fixed income portion, we will use short-term high-quality treasuries. But, for the purpose of this example we are going to keep it simple and use 50% equities and 50% fixed income.

 

(5:00) The amount we start out with in the fixed income portion is only used to control the initial amount of risk a client is willing to take.

 

One thing you’ll notice is there is no “stock picking” going on here. We are simply buying the entire asset class, or in other words, every company/holding within that asset class. If you don’t know how to do that in a low-cost and efficient manner, then feel free to contact me and I will point you in the right direction.

 

For our purposes today we are keeping it simple and just have 3 slices to our portfolio mix

 

(6:40) Portfolios that are NOT Rebalanced become RISKIER over time.

 

From this point we must understand that portfolios that are NOT rebalanced become riskier over time. It’s important to introduce a mathematical concept currently.  It is called standard deviation and rather than going into a long explanation and showing you the formula and how it’s calculated, the important thing to know is that it can be used to measure the risk of the asset classes in your portfolio.

 

If standard deviation can measure the risk of each asset class, then it can also measure the risk of the entire portfolio as a whole. In the simplest terms, the higher the standard deviation the more volatile your portfolio will be and the more the portfolio will deviate from the mean!

 

The more volatile your portfolio is, the more the variability of returns will be, much like a roller coaster at your favorite amusement park. Think of the monster roller coaster as having a high standard deviation- huge swings to the upside and downside and then think of the roller coaster in the kiddy park as having a low standard deviation- very mild swings to the upside and downside.

 

Feeling nauseous yet? Give me time….

 

So, if we look at this hypothetical portfolio over a period from 1973 to 2013, we can see the effects of rebalancing at various times vs. never rebalancing. Although you see the return increased to 11.96% by not rebalancing, the important thing to notice is what happened to the standard deviation of the portfolio. As you see, it increased over 40%. That’s 40% more risk. See exhibit C below.

 

Now this increase in risk goes back to our earlier discussion about choosing a mix that fits your risk/return preference. For example, if the original portfolio was chosen carefully and thoughtfully to meet your personal tolerance then an increase of 40% in risk is way outside of your comfort zone!

 

As a matter of fact, if the market randomly tanks (think of 2008) and you were assuming 40% more risk in your portfolio then you were initially comfortable with, then there is a really good chance you are going to “HIT” the panic button and sell when your portfolio drops.

 

By the way, this is exactly what we saw in the market crash of 2008. People panicked when the market crashed selling out of stocks at a peak in March of 2009 and moving to cash and fixed income just before the market began to rebound and went on to make new all-time highs.

 

If you had been properly rebalancing throughout that time……………your portfolio would not have been any risker than when you began.

 

And in that extreme example of a market crash like 08’, you would most likely have not hit the panic button.  Why? Because you maintained the original risk number you were comfortable with! Now it wouldn’t have felt good…….08’ was bad but having never rebalanced it would have been a lot worse and could have caused you to sell out at the very worst of times!

 

And by the way, at the end of 2008, by properly rebalancing you would have been selling fixed income –selling high and buying more stocks-buying low. The exact opposite of the average investor. This would have been the correct strategy to follow.

Exhibit C

 

(12:00) So what caused this increase in risk? Equities have historically tended to increase in value more frequently than fixed income and when they do, they have done so to a larger degree. In this hypothetical moderate portfolio, this resulted in the equity allocation increasing over time, which significantly increased the overall volatility as measured by standard deviation.

 

But the good news here is that the precise market movement that led to this increase in risk has also provided an opportunity to rebalance our portfolio back to its original allocation. This is a pure non-emotional strategy of selling just enough of the asset classes that increased and buying just enough of the asset classes that decreased and therefore, bringing us back to our original target.

 

Buy something at a low price, hold it, and eventually sell it at a higher price for profit in order to purchase something at a low price again. That is the goal of rebalancing in a nutshell.

 

(14:00) Let’s go back to our simple 50/50 mix and demonstrate a 2008 event:

 

For illustrative purposes only, let’s look at a very simplified two asset class portfolio of 50% US Large cap stocks and 50% US intermediate/long term bonds and compare how the average investor handles a market crash like 2008 vs. how an investor that follows a strict, risk target, rebalancing strategy would handle that same market decline.

 

We know US large cap stock as represented by the S&P 500 declined approximately 37% in 2008 and at the same time long term government bond index increased in value by approximately 26%. After 2008 this hypothetical portfolio would have had an asset mix of 67% fixed income and 33% US Stocks far from the starting point of 50/50.

 

The average investor at the end of 2008, spurned by the losses in their portfolios and the “overactive” media hype shouting “Armageddon” in the financial markets, dumped their equity holdings with a veracity we have never seen before.  And, at the same time, loaded up on intermediate and long-term bonds.

 

Essentially, there was what is commonly called a “flight to safety”. I on the other hand, have dubbed this a “fright to safety”. People were frightened about their losses and they chased after performance in a purely emotional decision-making strategy.

 

As a matter of fact, according to Morningstar US Open Flow Asset Update, this continued all the way through 2012.  The following was published in Morningstar in January of 2013: “outflows from actively managed U.S.-stock mutual funds in 2012 surpassed those seen in 2008 even though the S&P 500 was up 16% for the year.  Even when exchange-traded fund flows are included, large-cap U.S.-stock funds have seen net outflows over the trailing five-year period and in each of the past four years. Meanwhile, the S&P 500’s cumulative return over the five-year period is a respectable 8.59%. Investors haven’t just sat out the uneven stock market rally that began in March 2009; they have run from it and never looked back”.

 

(16:20) So what happened? WHAT HAPPENED IN 2009 AND MOST YEARS SINCE THE 08’ CRASH?

 

The result of this “fright to safety” was as follows. The following year, in 2009, large cap stocks represented by the S&P 500 increased by 26% and the asset class of long-term bonds declined by 14%.

 

So, the average investor did the exact opposite of what they were supposed to do. They essentially sold low and bought high, compounding their losses from the year before.

 

(17:00) SO NOW LETS CONTRAST THIS WITH WHAT A PRUDENT INVESTOR FOLLOWING A NON-EMOTIONAL REBALANCING STRATEGY THAT IS ON AUTOPILOT WOULD HAVE DONE DURING THAT SAME TIME FRAME

 

In this simplified example their portfolio would have been out of balance with the fixed income portion of long-term bonds representing a higher percentage of 67% of the portfolio than the equity portion of US large stocks at 33%.

 

So the strategy would have been as follows; rebalance the mix by selling the 17% of the fixed income class and buying 17% of US large stocks asset class, selling the asset class that increased (TOO HIGH) and buying more of the asset class that decreased (TOO LOW) based on our original target allocation of 50/50 that was chose based on your personal risk/return preference!

 

The following year you would have been rewarded with US stocks gaining in value 26%.  By the way, if US stocks declined again the following year you would have rebalanced again buying more at a lower price.

 

(19:00) Rebalancing may provide the opportunity of higher returns

 

While rebalancing is mainly about risk management in many periods, it can also provide the opportunity for obtaining additional premiums. One recent study on rebalancing a portfolio was conducted by Matson Money. According to this study, during one of the worst markets in recent history, rebalancing could have mitigated losses by maintaining appropriate portfolio weightings. In a diversified moderate portfolio of 50% equities and 50% fixed income, rebalancing during the period of January 2007 and December 2009 would have produced an increase in return of 2.79% versus not rebalancing.

(20:00) How often should you rebalance your portfolio?

 

The question then becomes how often should rebalancing take place? The basic answer to that question is “it depends”.   That is, it depends on is how much your portfolio veered from its target allocation.   So, it’s more important to look at this tolerance rather than the actual time frame.  I recommend looking at your allocations on a quarterly basis and allowing a 5% tolerance from your target.

 

For example, if you have an extremely diversified portfolio consisting of multiple asset classes that can be summarized or grouped as 50% fixed income, 30% US equities, and 20% International equities than as long as you are within 5% of those targets when reviewed on a quarterly basis, than rebalancing would not have to take place.  When the account allocation exceeds that 5% tolerance than rebalancing may be necessary.

Now, this does not mean we should ignore time frame all together.  There are important tax considerations in a taxable account to consider when rebalancing.  You should always consult a tax professional if you have any questions regarding your taxable investment account. If your portfolio has not been rebalanced in a year or so tax considerations become less important and maintaining your target asset allocations are far more important.

 

(22:40) Also, whenever possible it is wise to rebalance by using any cash that has accumulated either through regular periodic contributions or credited dividends to your cash account.  This allows you to rebalance more efficiently by being on only one side of the trade rather than having to initiate both a sell and a buy order and therefore, saving you a transaction fee.

 

Although it appears there is a lot to consider when rebalancing your portfolio this can be set up once and then placed on autopilot throughout your investing time frame.

 

Final Disclaimer:

“We appreciate you joining us today for this episode of The Fiscal Blueprint.

Be sure to visit fiscalblueprint.com to access the most recent content available including all past shows.

Remember it’s not about the money but about your life!

Having a mindset and living a life of abundance rather than scarcity will change the direction of your life forever!! Enjoy the Journey!!!

 

 

 

 

 

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