keeping your portfolio on track
It's easy to see why life events—a birth, marriage, college graduation or retirement—can trigger a change in your investment portfolio mix. But over time, market fluctuations can also make gradual changes to your investments and your risk exposure.
The portfolio rebalancing process is a critical and overlooked maintenance step, even though it can help you better align your investment strategy with your goals.
That's why it's important to periodically monitor and adjust the percentages of stocks, bonds and cash in your portfolio to keep them in sync with the targeted allocations you've chosen, says Anil Suri, managing director, chief investment officer, multi-asset class modeled solutions, Merrill Lynch Investment Management & Guidance. "The portfolio rebalancing process is a critical and often overlooked maintenance step, even though it can help you better align your investment strategy with your goals."
Rebalancing also may help you avoid trading on emotion. "As markets or investments soar or fall, many investors succumb to fears that they may be missing an opportunity or risking their principal," he notes. "Systematic rebalancing can help investors focus on the value of their entire portfolio and not just individual performance." In fact, Suri says, research shows that investors could improve returns by as much as 5% if they don't give in to reactive behavior like impulsive trading or buying high and selling low.1
1 Liersch, M. & Suri, A. (2012). Innovations in Behavioral Finance: How to Assess Your Investment Personality from the Merrill Lynch Wealth Management Institute and the academic studies cited therein.
Start with the appropriate mix
Although no investment methodology can guarantee success, the first step is to set targets for your allocation to stocks, bonds or cash — the process known as asset allocation.
The targets you set will reflect not only your risk tolerance, long-term goals and liquidity needs, but also the amount of time you have to pursue your goals. For instance, if you're saving for your child's college education, you might consider investing a portion of your equity holdings in more conservative investments as your high school student approaches graduation. The same is true for retirement; the closer you get, the less risk you may want to assume.
On the other hand, if you have a higher risk tolerance, you might want to consider more aggressive investments. The mix you choose should reflect the level of risk that suits your investment style, your time frame, your liquidity needs and your financial goals.
As you make asset allocation decisions, keep in mind the importance of diversification.
As you make asset allocation decisions, keep in mind the importance of diversification—spreading money across various investment types or, within a specific investment category, among a variety of companies, sectors or global regions.
Weighing stocks vs. bonds
When you weigh the long-term performance of stocks against bonds, the results show that over the long haul stocks have performed better but exposed investors to greater risk. That's why, despite the risk, many investors choose to hold more stocks than bonds, at least until they are nearing retirement.
Historical Rates of Return 1946-20142
Historical Rates of Return 1946-20143
2 Source for stock market returns: Merrill Lynch IMG Investment Analytics, Ibbotson. Stock Market: S&P 500 Total Return. Past performance does not guarantee future results. Results shown are based on indexes and are illustrative. They are gross of fees, do not take into account tax implications or transactions costs, and assume reinvestment of income.
3 Source for fixed-income returns: Merrill Lynch IMG Investment Analytics.
Fixed-Income: U.S. Long-Term Government Total Return. Past performance does not guarantee future results. Results shown are based on indexes and are illustrative. They are gross of fees, do not take into account tax implications or transactions costs, and assume reinvestment of income.
Diversification helps reduce the overall impact of a drastic increase or decline in the value of one asset class. If you hold a stock-heavy portfolio, for example, a market downturn can substantially reduce its value. One way to potentially mitigate this risk is to invest some of your funds in bonds and cash. These investments may provide a lower return, but they also represent less risk and don't tend to move in the same direction as stock prices.
You can potentially mitigate the risk of stocks by investing some of your funds in bonds and cash.
You also can diversify within asset classes. For example, you may choose to invest in large- and small-company stocks as well as domestic and foreign stocks. Or you may pick a mix of investment-grade and high-yield bonds.
Regardless of how you select your investments, remember that diversification can potentially lower your overall risk exposure and your portfolio's potential for volatility and is most effective when the types of investments you choose have different reactions to the market. This means that when one type of investment performs poorly, the other may perform better.
Asset allocation affects performance
Ultimately, your asset allocation affects how well your portfolio performs. Academic studies show that asset allocation decisions may be primarily responsible for the long-term return you achieve.4 Poor short-term performance in one asset class may be disappointing, but it shouldn't be viewed in isolation. How your assets work together to help you pursue your long-term investment goals is what matters most.
4 Brinson, G. P., Hood, L. R., & Beebower, G. L. (1986). "Determinants of Portfolio Performance." Financial Analysts Journal, Vol. 42 (4), 39-44. Asset allocation and diversification do not ensure a profit or protect against loss in declining markets.
The dangers of setting and forgetting
Over time, your investments will deliver varying rates of return—stocks may outperform bonds or vice versa. Eventually, market forces will cause the value of your holdings in various asset classes to change. For example, if you started with a 60/40 allocation in favor of stocks, you may end up closer to 75/25 after a bull market. This phenomenon, called "portfolio drift," may expose you to more risk. While your stock holdings may be worth more, they also suddenly represent a larger portion of your overall portfolio, and have unintentionally exposed you to a higher level of risk.
Eventually, market forces will change the value of your holdings which can affect your asset allocation.
A systematic rebalancing would prompt you to take some of those profits and reinvest them in bonds to help bring your allocation back to your original 60/40 allocation. "Some investors are hesitant to sell when the market is still up and maybe even rising, but by doing so you could potentially lock in your gains," explains Suri. This strategy, however, sometimes carries a cost.
The assumption behind rebalancing, he says, is that "anything unplanned that happens to your portfolio deserves scrutiny to make sure it is aligned with your goals, investment strategy, liquidity needs, time horizon and risk tolerance."
Portfolio drift and asset weightings
The chart shows how a portfolio with a moderate 60/40 stock-to-bond ratio that was never rebalanced was pushed out of alignment several times between 2002 and 2014 by market trends. At times, its fixed income holdings rose as high as 56.84%.
A portfolio drifts from its allocation
Source: Bloomberg, Merrill Lynch Investment Management & Guidance (IMG). Results shown are based on indexes and are illustrative. They are gross of fees, do not take into account tax implications or transactions costs, and assume reinvestment of income. Stocks and bonds are represented by the S&P 500 Total Return Index and the Barclays U.S. Aggregate Total Return Bond Index respectively. Asset allocation does not ensure a profit or protect against a loss in declining markets. Past performance does not guarantee future results.
The discipline of rebalancing
Rebalancing imposes a degree of discipline in investing. With rebalancing, you are prompted to take profits when investments perform better than expected and reinvest the proceeds in underperforming asset classes.
"While this may initially feel counterintuitive because you may leave some profit on the table, and riskier because you're investing in a sector that has been out of favor, it's a strategy that has worked over time," notes Suri. If you have your doubts, he says, consider what happened in the aftermath of the financial crisis of 2007-2009. After a decline of about 53% in the S&P 500® Index between October 2007 and March 2009, many investors avoided stocks. But after such a steep decline, stocks were undervalued, and history shows it was, in fact, a good time to buy; the S&P 500 doubled in value between March 2009 and May 2011.
Rebalancing won't always produce higher returns. For example, during a bull market for stocks, rebalancing requires selling assets that are trending higher while buying assets that are trending lower. At that point, a rebalanced portfolio would appear to have a disadvantage versus one that hadn't been rebalanced. However, when the markets shift direction, the investor who has rebalanced has the potential to achieve higher returns.
A hypothetical rebalancing
The chart shows how an investor could take profits on stock gains to get the equity portion back down to 60%, and then buy bonds to increase the fixed-income holding. While the sale of the stock may have lost some upside potential, the investor has clearly locked in the gain.
Rebalancing a portfolio
This is a hypothetical example of how to rebalance a portfolio meant for illustrative purposes only. Past performance does not guarantee future results.
The costs of rebalancing
Rebalancing usually requires selling certain assets and buying others, and these transactions may come at a cost. For example, if you trade stocks, you may be subject to commission charges. If you trade mutual funds, you could incur short-term trading fees or sales charges. And if you trade bonds, you may pay dealer concessions.
There also may be tax consequences. If you sell a security held in a taxable account at a profit, you will be subject to short-term or long-term capital gains taxes. Transaction costs and taxes will detract from your long-term performance, so you may want to choose a process that requires a minimal number of transactions and realized capital gains.
It is recommended that most investors rebalance at least once a year.
These are costs you must incorporate into any decision on how frequently to rebalance so you can avoid losing too much of your returns to transaction costs or taxes. Still, Suri suggests that most investors rebalance at least once a year.
Past performance does not guarantee future results.
Investing involves risk, including possible loss of the principal value invested. Equity securities are subject to stock market fluctuations that occur in response to economic and business developments. Dividend payments are not guaranteed and are paid only when declared by an issuer's board of directors. The amount of a dividend payment, if any, can vary over time.
Asset allocation, rebalancing and diversification do not ensure a profit or guarantee against loss. All asset classes are not suitable for all investors. Each investor should select the asset classes for them based on their goals, time horizon, liquidity needs and risk tolerance.
There are special risks associated with an investment in commodities, including market price fluctuations, regulatory changes, interest rate changes, credit risk, economic changes, and the impact of adverse political or financial factors.
Investments in foreign securities or sector funds, including technology or real estate stocks, are subject to substantial volatility due to adverse political, economic or other developments and may carry additional risk resulting from lack of industry diversification. Small or mid-capitalization companies experience a greater degree of market volatility than those of large-capitalization stocks and are riskier investments. Bond funds have the same interest rate, inflation, and credit risks associated with the underlying bonds owned by the fund. Generally, the value of bond funds rises when prevailing interest rates fall and falls when interest rates rise. Investing in lower-grade debt securities ("junk" bonds) may be subject to greater market fluctuations and risk of loss of income and principal than securities in higher rated categories. There are ongoing fees and expenses associated with investing. Bear in mind that higher return potential is accompanied by higher risk.
This material does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation, offer or solicitation for the purchase or sale of any security, financial instrument or strategy. Before acting on any information in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Any opinions expressed herein are given in good faith, are subject to change without notice, and are only correct as of the stated date of their issue.